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Nortel Networks 10-Q 2005
e10vq
Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

     
þ   Quarterly Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2004

OR

     
o   Transition Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934

For the Transition Period From ___________ to ___________

Commission file number 001-07260

Nortel Networks Corporation

(Exact name of registrant as specified in its charter)
     
Canada
(State or other jurisdiction of incorporation or
organization)
  Not Applicable
(I.R.S. Employer Identification No.)
     
8200 Dixie Road, Suite 100
Brampton, Ontario, Canada

(Address of principal executive offices)
  L6T 5P6
(Zip Code)

Registrant’s telephone number including area code (905) 863-0000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days.

Yes           No ü 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ü          No  

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as at February 28, 2005

4,268,236,086 without nominal or par value



 


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EXPLANATORY NOTE

Nortel Networks Corporation previously announced the need to restate its consolidated financial statements for the years ended December 31, 2002 and 2001 and each of its first three quarterly periods for 2003.

The unaudited consolidated statements of operations for the three and nine months ended September 30, 2003 and the unaudited consolidated statements of cash flows for the nine months ended September 30, 2003, including the applicable notes, contained in this Quarterly Report on Form 10-Q, have been restated.

A number of Nortel’s past filings with the United States Securities and Exchange Commission remain subject to ongoing review by the United States Securities and Exchange Commission’s Division of Corporation Finance. In addition, the Second Restatement (as defined below) involved the restatement of Nortel’s consolidated financial statements for 2001 and 2002 and the first, second and third quarters of 2003. Amendments to Nortel’s prior filings with the United States Securities and Exchange Commission would be required in order for Nortel to be in full compliance with Nortel’s reporting obligations under the Securities Exchange Act of 1934. However, Nortel does not believe that it will be feasible to amend Nortel’s Annual Report on Form 10-K/A for the year ended December 31, 2002, or 2002 Form 10-K/A, and our 2003 Quarterly Reports on Form 10-Q, or 2003 Form 10-Qs, due to, among other factors, identified material weaknesses in Nortel’s internal control over financial reporting, the significant turnover in Nortel’s finance personnel, changes in accounting systems, documentation weaknesses, a likely inability to obtain third party corroboration in certain cases due to the substantial industry adjustment in recent years and the passage of time generally. In addition, disclosure in the 2002 Form 10-K/A and 2003 Form 10-Qs would in large part repeat the disclosure contained in our 2003 Annual Report on Form 10-K, this report and our other 2004 Form 10-Qs. Accordingly, Nortel does not plan to amend our 2002 Form 10-K/A and 2003 Form 10-Qs. Nortel believes that it has included in our 2003 Annual Report on Form 10-K and in this report all information needed for current investor understanding. Ongoing United States Securities and Exchange Commission review may require Nortel to amend this Quarterly Report on Form 10-Q or Nortel’s other public filings.

For a description of the restatements, see “Restatement” in note 2 of the unaudited consolidated financial statements and “Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations — Developments in 2004 and 2005 — Nortel Audit Committee Independent Review; restatements; related matters” contained in this Quarterly Report on Form 10-Q.

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PART I
FINANCIAL INFORMATION

             
        PAGE
         
ITEM 1.       5  
 
ITEM 2.       65  
 
ITEM 3.       133  
 
ITEM 4.       133  
PART II
OTHER INFORMATION
ITEM 1.       146  
 
ITEM 6.       148  
 
SIGNATURES  
 
    149  

All dollar amounts in this document are in United States dollars unless otherwise stated.

NORTEL, NORTEL NETWORKS, NORTEL NETWORKS LOGO, NT, the GLOBEMARK, BAYSTACK, OPTERA and PASSPORT are trademarks of Nortel.

MOODY’S is a trademark of Moody’s Investor Services, Inc.

RCMP is a trademark of the Royal Canadian Mounted Police.

S&P and STANDARD & POOR’S are trademarks of The McGraw-Hill Companies, Inc.

Any other company or product names may be trademarks of their respective companies.

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PART I
FINANCIAL INFORMATION

             
        PAGE
         
ITEM 1.  
Consolidated Financial Statements (unaudited)
    5  
 
ITEM 2.  
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    65  
 
ITEM 3.  
Quantitative and Qualitative Disclosures About Market Risk
    133  
 
ITEM 4.  
Controls and Procedures
    133  

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NORTEL NETWORKS CORPORATION
Consolidated Statements of Operations (unaudited)

                                 
 
    Three months ended September 30,
          Nine months ended September 30,
 
(millions of U.S. dollars, except per share amounts)   2004     2003     2004     2003  

 
 
          As restated *           As restated *
 
                               
Revenues
  $ 2,179     $ 2,344     $ 7,213     $ 6,927  
Cost of revenues
    1,393       1,214       4,319       4,020  

 
Gross profit
    786       1,130       2,894       2,907  
 
                               
Selling, general and administrative expense
    512       527       1,596       1,458  
Research and development expense
    501       455       1,465       1,440  
Amortization of acquired technology and other
    2       32       7       98  
Deferred stock option compensation
          1             16  
Special charges
    93       80       99       198  
(Gain) loss on sale of businesses and assets
    (39 )     (17 )     (114 )     (6 )

 
Operating earnings (loss)
    (283 )     52       (159 )     (297 )
 
                               
Other income (expense) — net
    44       148       112       302  
Interest expense
                               
Long-term debt
    (45 )     (45 )     (132 )     (136 )
Other
    (3 )     (8 )     (18 )     (22 )

 
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net loss of associated companies
    (287 )     147       (197 )     (153 )
Income tax benefit (expense)
    30       (36 )     32       4  

 
 
    (257 )     111       (165 )     (149 )
Minority interests — net of tax
    (7 )     (10 )     (29 )     (52 )
Equity in net loss of associated companies — net of tax
          (13 )     (2 )     (38 )

 
Net earnings (loss) from continuing operations
    (264 )     88       (196 )     (239 )
Net earnings (loss) from discontinued operations — net of tax
    5       43       12       157  

 
Net earnings (loss) before cumulative effect of accounting change
    (259 )     131       (184 )     (82 )
Cumulative effect of accounting change — net of tax
                      (12 )

 
Net earnings (loss)
  $ (259 )   $ 131     $ (184 )   $ (94 )

 
 
                               
Basic earnings (loss) per common share
                               
— from continuing operations
  $ (0.06 )   $ 0.02     $ (0.04 )   $ (0.06 )
— from discontinued operations
    0.00       0.01       0.00       0.04  

 
Basic earnings (loss) per common share
  $ (0.06 )   $ 0.03     $ (0.04 )   $ (0.02 )

 
Diluted earnings (loss) per common share
                               
— from continuing operations
  $ (0.06 )   $ 0.02     $ (0.04 )   $ (0.06 )
— from discontinued operations
    0.00       0.01       0.00       0.04  

 
Diluted earnings (loss) per common share
  $ (0.06 )   $ 0.03     $ (0.04 )   $ (0.02 )

 

* See note 2

The accompanying notes are an integral part of these consolidated financial statements

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NORTEL NETWORKS CORPORATION
Consolidated Balance Sheets (unaudited)

                 
 
    September 30,     December 31,  
(millions of U.S. dollars)   2004     2003  

 
ASSETS
               
Current assets
               
Cash and cash equivalents
  $ 3,390     $ 3,997  
Restricted cash and cash equivalents
    77       63  
Accounts receivable — net
    2,134       2,505  
Inventories — net
    1,503       1,190  
Income taxes recoverable
    53       90  
Deferred income taxes — net
    229       369  
Other current assets
    312       315  

 
Total current assets
    7,698       8,529  
 
               
Investments
    170       244  
Plant and equipment — net
    1,591       1,656  
Goodwill
    2,304       2,305  
Intangible assets — net
    79       86  
Deferred income taxes — net
    3,610       3,397  
Other assets
    337       374  

 
Total assets
  $ 15,789     $ 16,591  

 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Current liabilities
               
Notes payable
  $ 13     $ 17  
Trade and other accounts payable
    703       861  
Payroll and benefit-related liabilities
    507       764  
Contractual liabilities
    636       530  
Restructuring liabilities
    190       206  
Other accrued liabilities
    2,400       2,505  
Long-term debt due within one year
    13       119  

 
Total current liabilities
    4,462       5,002  
 
               
Long-term debt
    3,862       3,891  
Deferred income taxes — net
    170       191  
Other liabilities
    2,938       2,945  

 
Total liabilities
    11,432       12,029  

 
 
               
Minority interests in subsidiary companies
    619       617  
 
               
Commitments and contingencies (notes 13 and 19)
               
 
               
SHAREHOLDERS’ EQUITY
               
Common shares, without par value — Authorized shares: unlimited; Issued and outstanding shares:
               
4,272,671,213 as of September 30, 2004 and 4,166,714,475 as of December 31, 2003
    33,840       33,674  
Additional paid-in capital
    3,261       3,341  
Accumulated deficit
    (32,716 )     (32,532 )
Accumulated other comprehensive loss
    (647 )     (538 )

 
Total shareholders’ equity
    3,738       3,945  

 
Total liabilities and shareholders’ equity
  $ 15,789     $ 16,591  

 

The accompanying notes are an integral part of these consolidated financial statements

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NORTEL NETWORKS CORPORATION
Consolidated Statements of Cash Flows (unaudited)

                 
 
    Nine months ended September 30,
 
(millions of U.S. dollars)   2004     2003  

 
 
          As restated *
 
               
Cash flows from (used in) operating activities
               
Net earnings (loss) from continuing operations
  $ (196 )   $ (239 )
Adjustments to reconcile net earnings (loss) from continuing operations to net cash from (used in) operating activities, net of effects from acquisitions and divestitures of businesses:
               
Amortization and depreciation
    260       429  
Non-cash portion of special charges and related asset write downs
          87  
Equity in net loss of associated companies
    2       38  
Stock option compensation
    55       35  
Deferred income taxes
    (12 )     (17 )
Other liabilities
    190       94  
Gain on repurchases of outstanding debt securities
          (4 )
(Gain) loss on sale or write down of investments and businesses
    (147 )     (8 )
Other — net
    (288 )     (618 )
Change in operating assets and liabilities
    (325 )     (82 )

 
Net cash from (used in) operating activities of continuing operations
    (461 )     (285 )

 
Cash flows from (used in) investing activities
               
Expenditures for plant and equipment
    (194 )     (105 )
Proceeds on disposals of plant and equipment
    10       22  
Acquisitions of investments and businesses — net of cash acquired
    (7 )     (53 )
Proceeds on sale of investments and businesses
    143       51  

 
Net cash from (used in) investing activities of continuing operations
    (48 )     (85 )

 
Cash flows from (used in) financing activities
               
Increase (decrease) in notes payable — net
    (2 )     (39 )
Repayments of long-term debt
    (107 )     (267 )
Repayments of capital leases payable
    (5 )     (9 )
Dividends paid by subsidiaries to minority interests
    (24 )     (26 )
Issuance of common shares
    30       2  

 
Net cash from (used in) financing activities of continuing operations
    (108 )     (339 )

 
Effect of foreign exchange rate changes on cash and cash equivalents
    (6 )     97  

 
Net cash from (used in) continuing operations
    (623 )     (612 )
Net cash from (used in) discontinued operations
    16       389  

 
Net increase (decrease) in cash and cash equivalents
    (607 )     (223 )
Cash and cash equivalents at beginning of period
    3,997       3,790  

 
Cash and cash equivalents at end of period
  $ 3,390     $ 3,567  

 

* See note 2

The accompanying notes are an integral part of these consolidated financial statements

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited)
(millions of U.S. dollars, except per share amounts, unless otherwise stated)

1.   Significant accounting policies
 
    Basis of presentation
 
    The unaudited consolidated financial statements of Nortel Networks Corporation (“Nortel”) have been prepared in accordance with accounting principles generally accepted in the United States (“U.S.”) (“GAAP”) and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”) for the preparation of interim financial information. They do not include all information and notes required by U.S. GAAP in the preparation of annual consolidated financial statements. The accounting policies used in the preparation of the unaudited consolidated financial statements are the same as those described in Nortel’s audited consolidated financial statements prepared in accordance with U.S. GAAP for the year ended December 31, 2003, except as described in note 3. Although Nortel is headquartered in Canada, the unaudited consolidated financial statements are expressed in U.S. dollars as the greater part of the financial results and net assets of Nortel are denominated in U.S. dollars.
 
    Nortel makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates. Estimates are used when accounting for items and matters such as revenue recognition and accruals for losses on contracts, allowances for uncollectible accounts receivable and customer financing, receivables sales, inventory obsolescence, product warranty, amortization, asset valuations, impairment assessments, employee benefits including pensions, taxes, restructuring and other provisions, stock-based compensation and contingencies.
 
    As described in note 2, the unaudited consolidated statements of operations for the three and nine months ended September 30, 2003, and the unaudited consolidated statement of cash flows for the nine months ended September 30, 2003, including the applicable notes, were restated.
 
    Nortel believes all adjustments necessary for a fair statement of the results for the periods presented have been made and all such adjustments were of a normal recurring nature unless otherwise disclosed. The financial results for the three and nine months ended September 30, 2004 are not necessarily indicative of financial results for the full year. The unaudited consolidated financial statements should be read in conjunction with Nortel’s Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC (“Nortel 2003 Annual Report”).
 
    Comparative figures
 
    Certain 2003 figures in the unaudited consolidated financial statements have been reclassified to conform to the 2004 presentation and certain 2003 figures have been restated as set out in note 2.
 
    Recent accounting pronouncements

  (a)   In March 2004, the Emerging Issues Task Force (“EITF”) reached consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”). EITF 03-1 provides guidance on determining when an investment is considered impaired, whether that impairment is other than temporary and the measurement of an impairment loss. EITF 03-1 is applicable to marketable debt and equity securities within the scope of Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”), and SFAS No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations”, and equity securities that are not subject to the scope of SFAS 115 and not accounted for under the equity method of accounting. In September 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) EITF 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, ‘The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments’”, which delays the effective date for the measurement and recognition criteria contained in EITF 03-1 until final application guidance is issued. The delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. The adoption of EITF 03-1 is not expected to have a material impact on Nortel’s results of operations and financial position.

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  (b)   On September 30, 2004, the EITF reached a consensus on Issue No. 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings Per Share” (“EITF 04-8”), which addresses when the dilutive effect of contingently convertible debt instruments should be included in diluted earnings (loss) per share. EITF 04-8 requires that contingently convertible debt instruments be included in the computation of diluted earnings (loss) per share regardless of whether the market price trigger has been met. EITF 04-8 also requires that prior period diluted earnings (loss) per share amounts presented for comparative purposes be restated. EITF 04-8 is effective for reporting periods ending after December 15, 2004. The adoption of EITF 04-8 will not have an impact on Nortel’s diluted earnings (loss) per share.
 
  (c)   In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”), which requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense in the consolidated financial statements based on their fair values. SFAS 123R also modifies certain measurement and expense recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), that will impact Nortel, including the requirement to estimate employee forfeitures each period when recognizing compensation expense, and requiring that the initial and subsequent measurement of the cost of liability-based service awards each period be based on the fair value (instead of the intrinsic value) of the award. This statement is effective as of the first interim or annual reporting period beginning after June 15, 2005. Nortel elected to expense employee stock-based compensation using the fair value method prospectively for all awards granted or modified on or after January 1, 2003 in accordance with SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of FASB Statement No. 123” (“SFAS 148”). Nortel is currently assessing the impact of SFAS 123R on its results of operations and financial position.
 
  (d)   In November 2004, the FASB issued SFAS No. 151, “Inventory Costs” (“SFAS 151”). SFAS 151 requires that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage), be recognized as current-period charges rather than capitalized as a component of inventory costs. In addition, SFAS 151 requires that allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. This statement is effective for inventory costs incurred in fiscal periods beginning after June 15, 2005. The guidance should be applied prospectively. Nortel is currently assessing the impact of SFAS 151 on its results of operations and financial position.

2.   Restatement
 
    First Restatement
 
    In May 2003, Nortel commenced certain balance sheet reviews at the direction of certain members of former management that led to a comprehensive review and analysis of its assets and liabilities (the “Comprehensive Review”), which resulted in the restatement (effected in December 2003) of its consolidated financial statements for the years ended December 31, 2002, 2001 and 2000 and for the quarters ended March 31, 2003 and June 30, 2003 (the “First Restatement”).
 
    The Comprehensive Review purported to (i) identify balance sheet accounts that, as of June 30, 2003, were not supportable and required adjustment; (ii) determine whether such adjustments related to the third quarter of 2003 or prior periods; and (iii) document certain account balances in accordance with Nortel’s accounting policies and procedures. The Comprehensive Review was supplemented by additional procedures carried out between July 2003 and November 2003 to quantify the effects of potential adjustments in the relevant periods and review the appropriateness of releases of certain contractual liability and other related provisions (also called accruals, reserves or accrued liabilities) in the six fiscal quarters ending with the fiscal quarter ended June 30, 2003 and formed the basis for the adjustments made to the financial statements in the First Restatement.
 
    On December 23, 2003, Nortel filed with the SEC an amended Annual Report on Form 10-K/A for the year ended December 31, 2002 (the “2002 Form 10-K/A”) and amended Quarterly Reports on Form 10-Q/A for the first and second quarters of 2003 (the “2003 Form 10-Q/As”) reflecting the First Restatement. As disclosed in those reports, the net effect of the First Restatement adjustments was a reduction in accumulated deficit of $497, $178 and $31 as of December 31, 2002, 2001 and 2000, respectively.
 
    Second Restatement
 
    In late October 2003, the Audit Committee of Nortel and Nortel Networks Limited (“NNL”) Boards of Directors (the “Audit Committee”) initiated an independent review of the facts and circumstances leading to the First Restatement (the “Independent Review”) and engaged the law firm now known as Wilmer Cutler Pickering Hale & Dorr LLP

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    (“WCPHD”) to advise it in connection with the Independent Review. The Audit Committee sought to gain a full understanding of the events that caused significant excess liabilities to be maintained on the balance sheet that needed to be restated, and to recommend that the Board adopt, and direct management to implement, necessary remedial measures to address personnel, controls, compliance and discipline. The Independent Review focused initially on events relating to the establishment and release of contractual liability and other related provisions in the second half of 2002 and the first half of 2003, including the involvement of senior corporate leadership. As the Independent Review evolved, its focus broadened to include specific provisioning activities in each of the business units and geographic regions. In light of concerns raised in the initial phase of the Independent Review, the Audit Committee expanded the review to include provisioning activities in the third and fourth quarters of 2003.
 
    As the Independent Review progressed, the Audit Committee directed new corporate management to examine in depth the concerns identified by WCPHD regarding provisioning activity and to review provision releases in each of the four quarters of 2003, down to a low threshold. That examination, and other errors identified by management, led to the restatement of Nortel’s consolidated financial statements for the years ended December 31, 2002 and 2001 and the quarters ended March 31, 2003 and 2002, June 30, 2003 and 2002 and September 30, 2003 and 2002 (the “Second Restatement”).
 
    Over the course of the Second Restatement process, management also identified certain accounting practices that it determined should be adjusted as part of the Second Restatement. In particular, management identified certain errors related to revenue recognition and undertook a process of revenue reviews. In light of the resulting adjustments to revenues previously reported, the Audit Committee has determined to review the facts and circumstances leading to the restatement of these revenues for specific transactions identified in the Second Restatement. This review will have a particular emphasis on the underlying conduct that led to the initial recognition of these revenues.
 
    Other accounting practices that management examined and adjusted as part of the Second Restatement included, among other things, the following:

    Nortel’s foreign exchange accounting as part of management’s plan to address an identified material weakness related to foreign currency translation;
 
    intercompany balances that did not eliminate upon consolidation and related provisions;
 
    the accounting treatment of the February 2001 acquisition of the 980 NPLC business from JDS Uniphase Corporation (“JDS”) and the related OEM Purchase and Sale Agreement;
 
    special charges relating to goodwill, inventory impairment, contract settlement costs and other charges; and
 
    the accounting treatment of certain elements of discontinued operations.

    Due to, among other factors, significant turnover in Nortel’s finance personnel, changes in accounting systems, documentation weaknesses and identified material weaknesses in internal control over financial reporting, the Second Restatement involved hundreds of Nortel finance personnel and a number of outside consultants and advisors. The process required the review and verification of a substantial number of documents and communications and related accounting entries over multiple fiscal periods. In addition, the review of accruals and provisions and the application of accounting literature to certain matters in the Second Restatement, including revenue recognition, foreign exchange, special charges and discontinued operations, was complicated by the passage of time, lack of availability of supporting records and the turnover of finance personnel. As a result of this complexity, estimates and assumptions that impact both the quantum of the various recorded adjustments and the fiscal period to which they were attributed were required in the determination of certain of the Second Restatement adjustments. Nortel believes the procedures followed in determining such estimates were appropriate and reasonable using the best available information.
 
    The following tables present the impact of the Second Restatement adjustments on Nortel’s previously reported consolidated statements of operations and a summary of the adjustments from the Second Restatement for the three and nine months ended September 30, 2003. The Second Restatement adjustments related primarily to the following items, each of which reflect a number of related adjustments that have been aggregated for disclosure purposes, and are described in the paragraphs following the tables below:

    Revenues and cost of revenues;
 
    Foreign exchange;

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    Intercompany balances;
 
    Special charges;
 
    Other;
 
    Reclassifications; and
 
    Discontinued operations.

Consolidated Statements of Operations

                                                 
 
    Three months ended September 30, 2003
    Nine months ended September 30, 2003
 
    As previously                     As previously              
    reported     Adjustments     As restated     reported     Adjustments     As restated  

 
Revenues
  $ 2,266     $ 78     $ 2,344     $ 6,981     $ (54 )   $ 6,927  
Cost of revenues
    1,074       140       1,214       3,717       303       4,020  

 
Gross profit
    1,192       (62 )     1,130       3,264       (357 )     2,907  
 
                                               
Selling, general and administrative expense
    486       41       527       1,413       45       1,458  
Research and development expense
    485       (30 )     455       1,470       (30 )     1,440  
Amortization of acquired technology and other
    32             32       98             98  
Deferred stock option compensation
    15       (14 )     1       50       (34 )     16  
Special charges
    70       10       80       180       18       198  
(Gain) loss on sale of businesses and assets
    (20 )     3       (17 )     (28 )     22       (6 )

 
Operating earnings (loss)
    124       (72 )     52       81       (378 )     (297 )
 
                                               
Other income (expense) — net
    100       48       148       127       175       302  
Interest expense
                                               
Long-term debt
    (45 )           (45 )     (134 )     (2 )     (136 )
Other
          (8 )     (8 )     (10 )     (12 )     (22 )

 
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net loss of associated companies
    179       (32 )     147       64       (217 )     (153 )
Income tax benefit (expense)
    (24 )     (12 )     (36 )     4             4  

 
 
    155       (44 )     111       68       (217 )     (149 )
Minority interests — net of tax
    (20 )     10       (10 )     (36 )     (16 )     (52 )
Equity in net loss of associated companies — net of tax
    (5 )     (8 )     (13 )     (35 )     (3 )     (38 )

 
Net earnings (loss) from continuing operations
    130       (42 )     88       (3 )     (236 )     (239 )
Net earnings (loss) from discontinued operations — net of tax
    55       (12 )     43       244       (87 )     157  

 
Net earnings (loss) before cumulative effect of accounting change
    185       (54 )     131       241       (323 )     (82 )
Cumulative effect of accounting change — net of tax
                      (8 )     (4 )     (12 )

 
Net earnings (loss)
  $ 185     $ (54 )   $ 131     $ 233     $ (327 )   $ (94 )

 
 
                                               
Basic and diluted earnings (loss) per common share
                                               
— from continuing operations
  $ 0.03     $ (0.01 )   $ 0.02     $ (0.00 )   $ (0.06 )   $ (0.06 )
— from discontinued operations
    0.01       0.00       0.01       0.05       (0.01 )     0.04  

 
Basic and diluted earnings (loss) per common share
  $ 0.04     $ (0.01 )   $ 0.03     $ 0.05     $ (0.07 )   $ (0.02 )

 

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Summary of Restatement Adjustments for the three months ended September 30, 2003:

                                                                 
 
    Revenues           Inter-                         Dis-        
    and cost of     Foreign     company     Special             Reclassifi-     continued     Total  
    revenues     exchange     balances     charges     Other     cations     operations     adjustments  

 
Revenues
  $ 78     $     $     $     $     $     $     $ 78  
Cost of revenues
    88       4       6             32       10             140  

 
Gross profit
    (10 )     (4 )     (6 )           (32 )     (10 )           (62 )
 
                                                               
Selling, general and administrative expense
                            38       3             41  
Research and development expense
                (4 )           (26 )                 (30 )
Deferred stock option compensation
                            (14 )                 (14 )
Special charges
                      10                         10  
(Gain) loss on sale of businesses and assets
                            (2 )     5             3  
Other income (expense) — net
          (4 )     2             32       18             48  
Interest expense — long term debt
                                               
Interest expense — other
                (4 )           (4 )                 (8 )
Income tax benefit (expense)
                            (12 )                 (12 )
Minority interests — net of tax
                            10                   10  
Equity in net loss of associated companies — net of tax
                            (8 )                 (8 )
Net earnings (loss) from discontinued operations — net of tax
                                        (12 )     (12 )
Cumulative effect of accounting change — net of tax
                                               

 
Total restatement adjustments
  $ (10 )   $ (8 )   $ (4 )   $ (10 )   $ (10 )   $     $ (12 )   $ (54 )

 

Summary of Restatement Adjustments for the nine months ended September 30, 2003:

                                                                 
 
    Revenues           Inter-                         Dis-        
    and cost of     Foreign     company     Special             Reclassifi-     continued     Total  
    revenues     exchange     balances     charges     Other     cations     operations     adjustments  

 
Revenues
  $ (54 )   $     $     $     $     $     $     $ (54 )
Cost of revenues
    120       13       4             138       28             303  

 
Gross profit
    (174 )     (13 )     (4 )           (138 )     (28 )           (357 )
 
                                                               
Selling, general and administrative expense
                2             29       14             45  
Research and development expense
                (9 )           (16 )     (5 )           (30 )
Deferred stock option compensation
                            (34 )                 (34 )
Special charges
                      18                         18  
(Gain) loss on sale of businesses and assets
                            4       18             22  
Other income (expense) — net
          110       (23 )           44       55       (11 )     175  
Interest expense — long term debt
                            (2 )                 (2 )
Interest expense — other
                (3 )           (9 )                 (12 )
Income tax benefit (expense)
                                               
Minority interests — net of tax
                            (16 )                 (16 )
Equity in net loss of associated companies — net of tax
                            (3 )                 (3 )
Net earnings (loss) from discontinued operations — net of tax
                                        (87 )     (87 )
Cumulative effect of accounting change — net of tax
                            (4 )                 (4 )

 
Total restatement adjustments
  $ (174 )   $ 97     $ (23 )   $ (18 )   $ (111 )   $     $ (98 )   $ (327 )

 

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The effect of the Second Restatement adjustments on the consolidated balance sheet as of September 30, 2003 is shown following the discussion below.

Revenues and cost of revenues

Revenues and cost of revenues were impacted by various errors related to revenue recognition, corrections to foreign exchange accounting, intercompany related items and other adjustments, including financial statement reclassifications. These items are further described below. The net impact to revenues of the adjustments was an increase of $78 and a decrease of $54 for the three and nine months ended September 30, 2003, respectively. The net impact to cost of revenues related to these revenue adjustments, and the other corrections was an increase of $140 and $303 for the three and nine months ended September 30, 2003, respectively. The following table summarizes the revenue recognition adjustments and other adjustments to revenues and cost of revenues, which decreased gross profit by $62 and $357 in the three and nine months ended September 30, 2003, respectively:

                                 
 
    Three months ended
September 30,

    Nine months ended
September 30,

 
            Cost of             Cost of  
    Revenues     revenues     Revenues     revenues  

 
Revenue recognition adjustments:
                               
Application of SAB 101 or SOP 97-2 (a)
                               
Title and delivery
  $ 8     $ 4     $ 43     $ 16  
Undelivered elements and liquidated damages
    (21 )     14       (119 )     26  
Application of SOP 81-1 (b)
    77       65       95       115  
 
                               
Persuasive evidence of an arrangement
    13       7              
Other revenue recognition adjustments
    1       (2 )     (73 )     (37 )

 
 
                               
Increase (decrease) associated with revenue recognition
    78       88       (54 )     120  
 
                               
Other adjustments:
                               
Foreign exchange
          4             13  
Intercompany
          6             4  
Other
          32             138  
Reclassifications
          10             28  

 
Increase (decrease) to revenues and cost of revenues
  $ 78     $ 140     $ (54 )   $ 303  

 

(a)   Staff Accounting Bulletin (“SAB”) 101, “Revenue Recognition in Financial Statements” (“SAB 101”); Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” (“SOP 97-2”).
(b)   SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (“SOP 81-1”).

Application of SAB 101 or SOP 97-2

Title and delivery

Revenues were recognized on certain sales (primarily prior to 2001) for which it was subsequently determined that the criteria for revenue recognition under SAB 101 or SOP 97-2, as applicable, had not been met, including arrangements in which legal title or risk of loss on products did not transfer to the buyer until full payment was received, and arrangements where delivery had not occurred. Revenues and related cost of revenues for these agreements should have been deferred until title or risk of loss had passed and all criteria for revenue recognition had been met. Therefore, adjustments were made to defer revenues and related cost of revenues from the periods in which they were originally recorded and to recognize them in the periods in which all revenue recognition criteria were met.

Undelivered elements and liquidated damages

In certain multiple element arrangements, total arrangement fees were recognized as revenue at the time of delivery of software or hardware, but prior to the delivery of future contractual or implicit post-contract support (“PCS”) or other services. Revenues should have been allocated to these future deliverables based on their fair value and recognized ratably over the PCS period or as the future obligations were performed. As well, in certain circumstances where the

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criteria to treat delivered software and hardware elements and undelivered PCS services as separate accounting units were not met, the entire arrangement fee should have been recognized over the PCS period. Adjustments were made to appropriately allocate revenue among the accounting units and recognize the allocated revenue in accordance with the applicable revenue recognition guidance.

Revenues were also recognized for certain contracts that involved undelivered elements as a result of product development delays. The lack of relative fair value for the undelivered element meant that revenues and cost of revenues for all products delivered should have been deferred until the undelivered element was delivered. As originally recorded, revenues were recognized upon delivery of an alternative product and costs were accrued for the undelivered element. To correct for these items, related cost provisions were reversed and revenues and associated cost of revenues were recognized in the appropriate periods when all elements had been delivered.

Revenues were recognized on certain contracts with potential liquidated damages arising primarily from network outages, shipment delays or product development delays on undelivered elements. Generally, revenues and related cost of revenues should have been deferred up to the maximum potential liquidated damages until the damages had been incurred or there was no longer a possibility of incurring such damages. Specific contracts, primarily in the Asia Pacific region, had the potential for liquidated damages plus right of return privileges if such damages exceeded contractually defined thresholds due to a product development delay (undelivered element). Revenues for all products delivered should have been deferred until the undelivered element was delivered. After delivery of the undelivered element, and in light of a lack of a reasonable and reliable history of comparable product returns on which to base a returns allowance, revenues should have been deferred until the right of return had lapsed or until expected returns could be reasonably estimated. After the right of return had lapsed or reasonable estimates of expected returns could be made, revenues should have continued to be deferred up to the amount of the maximum potential liquidated damages until either the earlier of when the damages were incurred, or there was no longer the possibility of incurring any damages. As originally recorded, cost provisions were recorded for the amount of the estimated damages and/or cost of product replacement. To correct these items, related cost provisions were reversed and revenues and associated cost of revenues were recognized in the appropriate periods.

Application of SOP 81-1

Adjustments were required to the application of percentage-of-completion accounting for certain long-term construction contracts. In the Europe, Middle East and Africa (“EMEA”) region, revenues and costs of revenues were not recognized using an appropriate measure of progress towards completion. An input method should have been used based on actual costs incurred and known/projected margin estimates at the time. This error was corrected, as well as other application errors that were identified across all regions.

Persuasive evidence of an arrangement

For a specific transaction in the Asia Pacific region, revenues were recognized after a notice of award was received but before a contract was executed. Revenues should have been deferred until a contract was executed. To correct for this item, revenues and related cost of revenues were deferred from the second quarter to the third quarter of 2003 when contract execution occurred.

Other revenue recognition adjustments

Other adjustments primarily included corrections related to an overstatement of revenues and cost of revenues as a result of two specific transactions recorded in the first quarter of 2003 which should have been recorded in 2002. In addition, other revenue recognition adjustments were made which related to a specific contract in the Caribbean and Latin America (“CALA”) region, other errors related to non-cash incentives and concessions provided to customers and other calculation errors.

Foreign exchange

As part of the plan to address a material weakness reported in Nortel’s Quarterly Report on Form 10-Q for the period ended September 30, 2003, a review of foreign exchange accounting was undertaken. The net impact was a decrease to pre-tax earnings of $8 and a decrease to pre-tax loss of $97 for the three and nine months ended September 30, 2003, respectively. The following presents the impact of these restatement adjustments on the consolidated statements of operations for the three and nine months ended September 30, 2003, which are described below:

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    Three months     Nine months  
    ended     ended  
    September 30,
2003
    September 30,
2003
 

 
Gross profit
               
Other errors
  $ (4 )   $ (13 )

 
Total increase (decrease) to gross profit
  $ (4 )   $ (13 )

 
Other income
               
Functional currency designation
  $ (3 )   $ 92  
Intercompany transaction designation
    (3 )     (59 )
Revaluation errors related to discontinued operations
    1       40  
Other errors
    1       37  

 
Total increase (decrease) to other income
  $ (4 )   $ 110  

 
Net impact to pre-tax earnings or loss
  $ (8 )   $ 97  

 

Functional currency designation

The determination of the functional currency for certain entities was re-examined, based on the guidance under SFAS No. 52, “Foreign Currency Translation” (“SFAS 52”). As a result, Nortel identified four instances in which the functional currency designation of an entity was incorrect. These revisions resulted in increases or decreases to other income (expense) — net.

Intercompany transaction designation

Nortel identified two instances of incorrect treatment of significant foreign currency translation gains and losses arising from intercompany positions. Under SFAS 52, intercompany foreign currency transactions that were long-term in nature should have been recorded in accumulated other comprehensive loss on the balance sheet when translated rather than recorded as a transactional gain or loss in the statement of operations. The net impact of the adjustments was an increase or decrease to other income (expense) — net, with an offset to accumulated other comprehensive loss.

Revaluation errors related to discontinued operations

Errors were identified in the revaluation of certain foreign denominated customer financing provisions within discontinued operations, the correction of which increased other income and decreased net earnings from discontinued operations.

Other errors

Other errors identified were related to translation of foreign denominated intercompany transactions, revaluation of certain foreign denominated intercompany transactions and accounting for mark-to-market adjustments for foreign exchange contracts as required under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”).

Intercompany balances

Historically, Nortel had certain intercompany balances that did not eliminate upon consolidation (“out-of-balance positions”), and provisions had been recorded accordingly. As part of the Second Restatement, Nortel reviewed these provisions and determined that they should not have been recorded. Adjustments were recorded in the appropriate periods to reverse these provisions and to correct the significant out-of-balance positions. The adjustments to reverse the provisions affected the second quarter of 2003 and periods prior to 2000. The net impact was a decrease of $4 to pre-tax earnings and an increase of $23 to pre-tax loss for the three and nine months ended September 30, 2003, respectively.

Special charges

As part of the Second Restatement, the components of special charges were re-examined and the impact to special charges was an increase of $10 and $18 for the three and nine months ended September 30, 2003, respectively. Adjustments for restructuring were recorded to special charges related to contract settlement costs, including real estate related items, severance and fringe benefit related costs and plant and

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equipment impairment costs. Nortel determined that these items were either recorded in special charges in error or, although correctly recorded when originally recognized, were not adjusted in the appropriate subsequent periods for changes in estimates and/or assumptions. The following presents the impact of these other adjustments on special charges for the three and nine months ended September 30, 2003:

                 
 
    Three months     Nine months  
    ended September 30,     ended September 30,  
    2003     2003  

 
Contract settlement costs
  $ 10     $ (18 )
Plant and equipment impairment costs
          32  
Severance and fringe benefit related costs
          4  

 
Total increase (decrease) to special charges
  $ 10     $ 18  

 

Other

Other adjustments recorded were primarily to correct certain accruals, provisions or other transactions which were either initially recorded incorrectly in prior periods, or not properly released or adjusted for changes in estimates and/or assumptions in the appropriate subsequent periods. The components of these adjustments for the three and nine months ended September 30, 2003, are described below.

                 
 
    Three months     Nine months  
    ended September 30,     ended September 30,  
    2003     2003  

 
Other adjustments
               
Cost of revenues
  $ (32 )   $ (138 )
Selling, general and administrative expense
    (38 )     (29 )
Research and development expense
    26       16  
Deferred stock option compensation
    14       34  
(Gain) loss on sale of businesses and assets
    2       (4 )
Other income (expense) — net
    32       44  
Interest expense
    (4 )     (11 )
Income tax benefit (expense)
    (12 )      
Minority interests — net of tax
    10       (16 )
Equity in net loss of associated companies — net of tax
    (8 )     (3 )
Cumulative effect of accounting changes — net of tax
          (4 )

 
Net impact to earnings or loss
  $ (10 )   $ (111 )

 

Cost of revenues

For the three months ended September 30, 2003, the increase to cost of revenues of $32 was comprised primarily of an increase of approximately $15 for inventory and product related accruals, approximately $12 for customer and contract related accruals and approximately $8 for warranty costs, partially offset by $3 related to other accruals.

For the nine months ended September 30, 2003, the increase to cost of revenues of $138 was comprised primarily of an increase of approximately $51 for customer and contract related accruals, approximately $43 for warranty costs, approximately $30 for inventory and product related accruals, and approximately $14 related to other accruals.

Selling, general and administrative expense

For the three months ended September 30, 2003, the increase of $38 to selling, general and administrative expense was comprised primarily of an increase of approximately $6 related to contract amendments and settlements with certain service providers and an increase of approximately $44 to other accruals, partially offset by a decrease of approximately $3 related to bad debt expense and approximately $9 to reflect net adjustments to the timing of employee bonus related accruals.

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For the nine months ended September 30, 2003, the increase of $29 to selling, general and administrative expense was comprised primarily of an increase of approximately $48 related to contract amendments and settlements with certain service providers and an increase of approximately $83 to other accruals, partially offset by decreases of approximately $51 related to bad debt expense and approximately $51 to reflect net adjustments to the timing of employee bonus related accruals.

Research and development expense

For the three months ended September 30, 2003, the decrease of $26 in research and development expense was primarily the result of a decrease of approximately $15 to correctly treat certain software repair costs as warranty costs and a net decrease of approximately $11 related to accruals regarding various research and development projects and other accruals.

For the nine months ended September 30, 2003, the decrease of $16 in research and development expense was primarily the result of approximately $45 to correctly treat certain software repair costs as warranty costs, partially offset by an increase of approximately $29 related to accruals regarding various research and development projects and other accruals.

Deferred stock option compensation

For the three and nine months ended September 30, 2003, the decrease of $14 and $34, respectively, in deferred stock option compensation was the result of a correction to the calculation of the valuation of deferred compensation on an acquisition in a prior year.

Other income (expense) — net

For the three months ended September 30, 2003, the increase of $32 in other income was primarily the result of adjustments of approximately $13 related to sales and use and other tax provisions, and approximately $19 related to other accruals.

For the nine months ended September 30, 2003, the increase of $44 in other income was primarily the result of an increase of approximately $17 from corrections to the timing of the recognition of the impairment of certain investments, approximately $16 for unused customer credits originally recognized as a reduction to customer revenues in this period and approximately $35 related to other accruals, partially offset by an adjustment of approximately $15 related to sales of receivables and customer financing and a decrease of approximately $9 related to sales and use and other tax accruals.

Interest expense

For the three months ended September 30, 2003, the increase to interest expense of $4 was primarily related to long-term debt for corrections to accounting for certain sale-leaseback transactions.

For the nine months ended September 30, 2003, the increase to interest expense of $11 was primarily the result of a $13 increase related to long-term debt for corrections to accounting for certain sale-leaseback transactions, partially offset by a $2 decrease from adjustments to the timing of the recognition of costs associated with sales of receivables and customer financing.

Income taxes, minority interests and equity in net loss of associated companies — net of tax

Income tax benefit (expense) and minority interests were also adjusted as part of the Second Restatement. The adjustment to income taxes was an increase of $12 to income tax expense and nil to income tax benefit (expense) for the three and nine months ended September 30, 2003, respectively, primarily related to the tax impact of the restatements, investment tax credits and taxes attributable to preferred share dividends. The adjustment to minority interests — net of tax as a result of the Second Restatement adjustments was a decrease of $10 and an increase of $16 for the three and nine months ended September 30, 2003, respectively.

As part of the Second Restatement, equity in net loss of associated companies — net of tax was adjusted to reflect the final reported losses of the associated companies for the period rather than the estimates that were used when originally recorded. The adjustment resulted in a decrease to net earnings of $8 and an increase to net loss of $3 for the three and nine months ended September 30, 2003, respectively.

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Reclassifications

As a result of the restatement process, various presentation inconsistencies were identified. Adjustments were made to appropriately reflect certain items in the consolidated statements of operations. The reclassifications were made for royalty expense, (gain) loss on sale of businesses and assets and other items including certain functional spending and specific expenses. The amounts that were reclassified for the three and nine months ended September 30, 2003 are detailed below:

                                 
 
    Royalty     Disposal              
    expense     of assets     Other     Total  

 
Three months ended September 30, 2003
                               
Cost of revenues
  $ 13     $     $ (3 )   $ 10  
Selling, general and administrative expense
                3       3  
(Gain) loss on sale of businesses and assets
          5             5  
Other expense
    (13 )     (5 )           (18 )

 
Net impact of reclassifications
  $     $     $     $  

 
Nine months ended September 30, 2003
                               
Cost of revenues
  $ 37     $     $ (9 )   $ 28  
Selling, general and administrative expense
                14       14  
Research and development expense
                (5 )     (5 )
(Gain) loss on sale of businesses and assets
          18             18  
Other expense
    (37 )     (18 )           (55 )

 
Net impact of reclassifications
  $     $     $     $  

 

Discontinued operations

As a result of the restatement process, the initial provision for loss on disposal of the access solutions discontinued operations recorded in June 2001, and the subsequent activity during 2001 through 2004 were re-examined. Nortel concluded that the net loss on disposal of operations recognized in the second quarter of 2001 was overstated. In addition, other adjustments were necessary to correct certain items that were either initially recorded incorrectly, or not properly released or adjusted for changes in estimates in the appropriate periods subsequent to the second quarter of 2001. The net impact of the adjustments was a decrease of $12 and $87 (net of tax of $1), respectively, to the previously reported net earnings from discontinued operations for the three and nine months ended September 30, 2003.

For the three months ended September 30, 2003, the $12 decrease to net earnings from discontinued operations consisted primarily of decreases resulting from additional provisions related to discontinued operations.

For the nine months ended September 30, 2003, the $87 decrease to net earnings from discontinued operations consisted primarily of a decrease of approximately $90 resulting from the elimination of a gain on redemption of an investment interest due to the reversal in an earlier period of a full valuation allowance that had been recorded against the investment interest when acquired, a decrease of approximately $39 related to the revaluation of certain foreign denominated customer financing provisions and a net decrease of approximately $24 resulting from additional provisions related to discontinued operations, partially offset by a $51 net increase from adjustments to contingent liabilities and an increase of approximately $11 related to a gain on settlement of a sales representation agreement which had previously been recorded in continuing operations.

Balance sheet

The following table presents the impact of the Second Restatement adjustments on Nortel’s previously reported consolidated balance sheet as of September 30, 2003. The impact on inventories — net and various liabilities, including deferred revenue, was primarily due to the adjustments to revenues and cost of revenues described above. The adjustments to plant and equipment — net and long-term debt primarily related to corrections to the accounting for certain sale-leaseback transactions. In addition, there were reclassifications resulting from the restatement adjustments and to conform to the 2003 presentation in the consolidated balance sheet.

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Consolidated Balance Sheet as of September 30, 2003  
                         
 
    As previously              
    reported     Adjustments     As restated  

 
ASSETS
                       
Current assets
                       
Cash and cash equivalents
  $ 3,566     $ 1     $ 3,567  
Restricted cash and cash equivalents
    113             113  
Accounts receivable — net
    2,065       (37 )     2,028  
Inventories — net
    928       501       1,429  
Income taxes recoverable
    63       5       68  
Deferred income taxes — net
    415             415  
Other current assets
    419       (15 )     404  

 
Total current assets
    7,569       455       8,024  
 
                       
Investments
    183       88       271  
Plant and equipment — net
    1,470       196       1,666  
Goodwill
    2,233       48       2,281  
Intangible assets — net
    92             92  
Deferred income taxes — net
    3,224       (5 )     3,219  
Other assets
    511       (102 )     409  

 
Total assets
  $ 15,282     $ 680     $ 15,962  

 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                       
Current liabilities
                       
Notes payable
  $ 23     $     $ 23  
Trade and other accounts payable
    768       (59 )     709  
Payroll and benefit-related liabilities
    708       32       740  
Contractual liabilities
    768       (165 )     603  
Restructuring
    273       (64 )     209  
Other accrued liabilities
    2,311       401       2,712  
Long-term debt due within one year
    112       7       119  

 
Total current liabilities
    4,963       152       5,115  
 
                       
Long-term debt
    3,758       130       3,888  
Deferred income taxes — net
    280       (24 )     256  
Other liabilities
    2,289       361       2,650  

 
Total liabilities
    11,290       619       11,909  

 
Minority interests in subsidiary companies
    613       8       621  
 
SHAREHOLDERS’ EQUITY
                       
Common shares, without par value
    33,802       (350 )     33,452  
Additional paid-in capital
    3,554       1       3,555  
Deferred stock option compensation
    (38 )     38        
Accumulated deficit
    (33,006 )     (54 )     (33,060 )
Accumulated other comprehensive loss
    (933 )     418       (515 )

 
Total shareholders’ equity
    3,379       53       3,432  

 
Total liabilities and shareholders’ equity
  $ 15,282     $ 680     $ 15,962  

 

3.   Accounting changes

  (a)   Stock-based compensation
 
      Effective January 1, 2003, Nortel elected to expense employee stock-based compensation using the fair value based method prospectively for all awards granted or modified on or after January 1, 2003 in accordance with SFAS 148. Prior to January 1, 2003, Nortel, as permitted by SFAS 123, applied the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, and related interpretations, in accounting for its employee stock-based compensation plans. The fair value at grant date of stock options is estimated using the Black-Scholes option-pricing model. Compensation

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      expense is recognized on a straight line basis over the vesting period of the award. Compensation expense is adjusted for the forfeiture of non-vested awards in the period when the forfeiture occurs.
 
      Had Nortel applied the fair value based method to all stock-based awards in all periods, reported net earnings (loss) and earnings (loss) per common share would have been adjusted to the pro forma amounts indicated below for each of the three and nine months ended September 30:
                                 
 
    Three months ended September 30,
    Nine months ended September 30,
 
    2004     2003     2004     2003  

 
Net earnings (loss) — reported
  $ (259 )   $ 131     $ (184 )   $ (94 )
Stock-based compensation — reported (a)
    17       30       95       47  
Deferred stock option compensation — reported (b)
          1             16  
Stock-based compensation — pro forma (c)
    (34 )     (115 )     (190 )     (405 )

 
Net earnings (loss) — pro forma
  $ (276 )   $ 47     $ (279 )   $ (436 )

 
Basic earnings (loss) per common share:
                               
Reported
  $ (0.06 )   $ 0.03     $ (0.04 )   $ (0.02 )
Pro forma
  $ (0.06 )   $ 0.01     $ (0.06 )   $ (0.10 )

 
Diluted earnings (loss) per common share:
                               
Reported
  $ (0.06 )   $ 0.03     $ (0.04 )   $ (0.02 )
Pro forma
  $ (0.06 )   $ 0.01     $ (0.06 )   $ (0.10 )

 
  (a)   Stock-based compensation — reported, included:
  i.   Stock option expense for the three and nine months ended September 30, 2004 of $20 and $55, respectively, which was net of tax of nil in each period. For the three and nine months ended September 30, 2003, the amounts were $7 and $19, respectively, which was net of tax of nil in each period;
  ii.   Employer portion of stock purchase plan contributions expense for the three and nine months ended September 30, 2004 of nil (see note 15). For the three and nine months ended September 30, 2003, the amounts were $2 and $5, respectively, which was net of tax of nil in each period;
  iii.   Restricted stock units expense for the three and nine months ended September 30, 2004 of nil and $41, respectively, which was net of tax of nil in each period. For the three and nine months ended September 30, 2003, the amounts were $19 and $19, respectively, which were net of tax of nil in each period; and
  iv.   Deferred stock units expense for the three and nine months ended September 30, 2004 of $(3) and $(1), respectively, which was net of tax of nil in each period. For the three and nine months ended September 30, 2003, the amounts were $2 and $4, respectively, which was net of tax of nil in each period.
  (b)   Deferred stock option compensation — reported represented the amortization of deferred stock option compensation related primarily to unvested stock options held by employees of companies acquired in a purchase acquisition. For the three and nine months ended September 30, 2004, the amounts were net of tax of nil in each period. For the three and nine months ended September 30, 2003, the amounts were $1 and $16, respectively, which was net of tax of nil in each period.
  (c)   Stock-based compensation — pro forma was net of tax of nil in each period.

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      The following weighted-average assumptions were used in computing the fair value of stock options for each of the three months and nine months ended September 30:
                                 
 
    Three months ended September 30,
    Nine months ended September 30,
 
    2004 (a)     2003     2004     2003  

 
Black-Scholes weighted-average assumptions
                               
Expected dividend yield
          0.00 %     0.00 %     0.00 %
Expected volatility
          93.29 %     94.49 %     92.49 %
Risk-free interest rate
          3.17 %     2.96 %     2.81 %
Expected option life in years
          4       4       4  
 
                               
Weighted-average stock option fair value per option granted
  $     $ 1.94     $ 5.21     $ 1.57  

 
  (a)   For the three months ended September 30, 2004, no stock options were granted.

  (b)   Asset retirement obligations
 
      In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”), which applies to certain legal obligations associated with the retirement of tangible long-lived assets. SFAS 143 requires that a liability be initially recognized for the estimated fair value of the obligation when it is incurred. The associated asset retirement cost is capitalized as part of the carrying amount of the long-lived asset and depreciated over the remaining life of the underlying asset and the associated liability is accreted to the estimated fair value of the obligation at the settlement date through periodic accretion charges to net earnings (loss). When the obligation is settled, any difference between the final cost and the recorded amount is recognized as income or loss on settlement. Effective January 1, 2003, Nortel adopted the initial recognition and measurement provisions of SFAS 143 and identified certain asset retirement obligations to remediate leased premises and buildings and equipment situated on leased land. The adoption of SFAS 143 resulted in an increase to net loss of $12 (net of tax of nil) which has been reported as a cumulative effect of accounting change — net of tax, an increase in plant and equipment — net of $4 and an asset retirement obligation liability of $16 as of January 1, 2003. The adoption of SFAS 143 did not have a material impact on depreciation and accretion expense or basic and diluted earnings (loss) per share.
 
  (c)   Accounting for certain financial instruments with characteristics of both liabilities and equity
 
      In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity, including mandatorily redeemable non-controlling interests, and requires that those instruments be classified as liabilities on the balance sheets. Previously, many of those financial instruments were classified as equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. In November 2003, the FASB issued FSP Financial Accounting Standard (“FSP FAS”) 150-3, “Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Non-controlling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” (“FSP FAS 150-3”), which deferred indefinitely the effective date for applying the specific provisions within SFAS 150 related to the classification and measurement of mandatorily redeemable non-controlling interests. The adoption of SFAS 150, as amended by FSP FAS 150-3, did not have a material impact on Nortel’s results of operations and financial position.
 
      As of December 31, 2003 and September 30, 2004, Nortel continued to consolidate two enterprises with limited lives. Upon liquidation in 2024, the net assets of these entities will be distributed to the owners based on their relative interests at that time. The minority interest included in the consolidated balance sheet related to these entities as of September 30, 2004 was $44. Nortel has not yet determined the fair value of this minority interest as of September 30, 2004.

4.   Consolidated financial statement details
 
    The following consolidated financial statement details are presented for each of the three and nine months ended September 30, 2004 and 2003 for the consolidated statements of operations, as of September 30, 2004 and December 31, 2003 for the consolidated balance

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    sheets and for each of the nine months ended September 30, 2004 and 2003 for the consolidated statements of cash flows.
 
    Consolidated statements of operations
 
    In August 2004, Nortel entered into a contract with Bharat Sanchar Nigram Limited to establish a wireless network in India. Nortel’s commitments to date for orders received under this contract have resulted in an estimated project loss of approximately $159, which has been recorded as cost of revenues and accrued within contractual liabilities in the third quarter of 2004.
 
    During the third quarter of 2004, Nortel reduced revenue by approximately $80 to correct for previously recognized revenue relating to past sales of Optical Networks equipment which we subsequently determined should have been deferred and recognized with the delivery of future contractual PCS and other services over the term of the PCS. The associated costs of revenues were also deferred resulting in no significant impact on Nortel’s gross margin as a percentage of revenues in the third quarter of 2004.
 
    During the three and nine months ended September 30, 2003, Nortel reversed provisions of $68 and $87, respectively, relating to a customer bankruptcy settlement, which had the effect of reducing cost of revenues by $53 and $53, respectively, and selling, general and administrative (“SG&A”) expense by nil and $4, respectively, and increasing other income (expense) — net by $15 and $30, respectively.
 
    Other income (expense) — net:
                                 
 
    Three months ended September 30,
    Nine months ended September 30,
 
    2004     2003     2004     2003  

 
Interest income
  $ 16     $ 15     $ 47     $ 53  
Gain (loss) on sale or write down of investments
    1       11       33       2  
Currency exchange gains (losses)
    53       7       53       113  
Other — net
    (26 )     115       (21 )     134  

 
Other income (expense) — net
  $ 44     $ 148     $ 112     $ 302  

 

    Other income (expense) — net includes a gain of $31 resulting from a correction in the third quarter of 2004 relating to a cumulative error in functional currency designation of an entity in Brazil.
 
    Consolidated balance sheets
 
    Accounts receivable — net:
                 
 
    September 30,     December 31,  
    2004     2003  

 
Trade receivables
  $ 1,721     $ 2,117  
Contracts in process
    538       582  

 
 
    2,259       2,699  

 
Less: provision for doubtful accounts
    (125 )     (194 )

 
Accounts receivable — net
  $ 2,134     $ 2,505  

 

    Inventories — net:
                 
 
    September 30,     December 31,  
    2004     2003  

 
Raw materials
  $ 109     $ 249  
Work in process
    359       221  
Finished goods
    1,035       720  

 
Inventories — net (a)
  $ 1,503     $ 1,190  

 
  (a)   Net of inventory provisions of $1,045 and $1,226 as of September 30, 2004 and December 31, 2003, respectively. Other reserves for claims related to contract manufacturers and suppliers of $61 and $120 as of September 30, 2004 and December 31, 2003, respectively, were included in other accrued liabilities. These accruals were related to cancellation charges, contracted-for inventory in excess of future demand and the settlement of certain other claims.

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    Other current assets:
                 
 
    September 30,     December 31,  
    2004     2003  

 
Prepaid expenses
  $ 206     $ 176  
Current assets of discontinued operations (a)
    19       28  
Other
    87       111  

 
Other current assets
  $ 312     $ 315  

 
  (a)   See note 18 for additional information.

    Plant and equipment — net:
                 
 
    September 30,     December 31,  
    2004     2003  

 
Cost:
               
Land
  $ 62     $ 62  
Buildings
    1,428       1,483  
Machinery and equipment
    2,525       2,749  

 
 
    4,015       4,294  

 
Less accumulated depreciation:
               
Buildings
    (442 )     (457 )
Machinery and equipment
    (1,982 )     (2,181 )

 
 
    (2,424 )     (2,638 )

 
Plant and equipment — net (a) (b) (c)
  $ 1,591     $ 1,656  

 
  (a)   Included assets held for sale with a carrying value of $26 and $30 as of September 30, 2004 and December 31, 2003, respectively, related to owned facilities that were being actively marketed. These assets were written down in previous periods to their estimated fair values less costs to sell. The write downs were included in special charges. Nortel expects to dispose of all of these facilities by mid-2005.
  (b)   Included variable interest entity assets consolidated prospectively, as required by FASB Interpretation No. 46 (Revised 2003), “Consolidation of Variable Interest Entities - An Interpretation of Accounting Research Bulletin No. 51” (“FIN 46R”), of $91 and $183 as of September 30, 2004 and December 31, 2003, respectively.
  (c)   Included the impact of leases recorded prospectively, as required by EITF 01-8, “Determining Whether an Arrangement Contains a Lease”, of $3 and $2 as of September 30, 2004 and December 31, 2003, respectively.

    Goodwill:
 
    The following table outlines goodwill by reportable segment:
                                         
 
    Wireless     Enterprise     Wireline     Optical        
    Networks     Networks     Networks     Networks     Total  

 
Balance — net as of December 31, 2003
  $ 35     $ 1,692     $ 569     $ 9     $ 2,305  
Change:
                                       
Foreign exchange
          (1 )                 (1 )

 
Balance — net as of September 30, 2004
  $ 35     $ 1,691     $ 569     $ 9     $ 2,304  

 

    Intangible assets — net:
                 
 
    September 30,     December 31,  
    2004     2003  

 
Other intangible assets (a)
  $ 38     $ 45  
Pension intangible assets (b)
    41       41  

 
Intangible assets — net
  $ 79     $ 86  

 
  (a)   Other intangible assets are being amortized over a ten year period ending in 2013, based on their expected pattern of benefit to future periods using estimates of undiscounted cash flows. The amortization expense is denominated in a foreign currency and may fluctuate due to changes in foreign exchange rates.

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  (b)   Pension intangible assets were recorded as required by SFAS No. 87, “Employers’ Accounting for Pensions”. Amounts are not amortized but are adjusted as part of the annual minimum pension liability assessment.

    Other accrued liabilities:
                 
 
    September 30,     December 31,  
    2004     2003  

 
Outsourcing and selling, general and administrative related
  $ 334     $ 302  
Customer deposits
    34       73  
Product related
    61       120  
Warranty
    305       387  
Deferred income
    895       761  
Miscellaneous taxes
    46       76  
Income taxes payable
    82       111  
Current liabilities of discontinued operations
    1       6  
Interest payable
    30       62  
Advance billings in excess of revenues recognized on long-term contracts
    500       509  
Other
    112       98  

 
Other accrued liabilities
  $ 2,400     $ 2,505  

 

    Other liabilities:
                 
 
    September 30,     December 31,  
    2004     2003  

 
Pension, post-employment and post-retirement benefits liabilities
  $ 2,013     $ 1,973  
Long-term provisions
    925       972  

 
Other liabilities
  $ 2,938     $ 2,945  

 

    Related party transactions:
 
    In the ordinary course of business, Nortel purchases equipment from Bookham Inc. (“Bookham”), a related party due to Nortel’s approximate 12% equity interest in Bookham. During the nine months ended September 30, 2004 and 2003, Nortel’s aggregate purchases from Bookham were $40 and $61, respectively. As of September 30, 2004 and December 31, 2003, accounts payable to Bookham were $11 and $7, respectively. Nortel also has certain notes receivable due from Bookham with a carrying amount of $21 and $19 as of September 30, 2004 and December 31, 2003, respectively.
 
    See note 9 for additional related party transactions.
 
    Consolidated statements of cash flows
 
    Change in operating assets and liabilities:
                 
 
    September 30,     September 30,  
    2004     2003  

 
Restricted cash and cash equivalents
  $ (14 )   $ 147  
Accounts receivable
    355       223  
Inventories
    (313 )     158  
Income taxes
    (64 )     23  
Restructuring
    (178 )     (451 )
Accounts payable and accrued liabilities
    (427 )     (492 )
Other operating assets and liabilities
    316       310  

 
Change in operating assets and liabilities
  $ (325 )   $ (82 )

 

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    Interest and taxes paid:
                 
 
    September 30,     September 30,  
    2004     2003  

 
Cash interest paid
  $ 182     $ 137  
Cash taxes paid — net
  $ 39     $ 8  

 

5.   Segment information
 
    General description
 
    During 2003 and up to September 30, 2004, Nortel’s operations were organized around four reportable segments consisting of Wireless Networks, Enterprise Networks, Wireline Networks and Optical Networks. Wireless Networks included network access and core networking products for voice and data communications that span second and third generation wireless technologies and most major global standards for mobile networks and related professional services. Enterprise Networks included circuit and packet voice solutions, data networking and security solutions and the related professional services used by enterprise customers. Wireline Networks included circuit and packet voice solutions, data networking and security solutions and the related professional services used by service provider customers. Optical Networks included metropolitan, regional and long-haul optical transport and switching solutions and managed broadband services and related professional services for both service provider and enterprise customers.
 
    “Other” represented miscellaneous business activities and corporate functions. None of these activities meet the quantitative criteria to be disclosed as reportable segments. As described in note 18, Nortel’s access solutions operations were discontinued during the year ended December 31, 2001. These operations were previously included as a separate business activity within “other”. The data below excludes amounts related to the access solutions operations.
 
    Effective October 1, 2004, Nortel established a new streamlined organizational structure that included, among other things, combining the businesses of Nortel’s four segments into two business organizations: (i) Carrier Networks and Global Operations, and (ii) Enterprise Networks. Nortel has reviewed the impact of these changes on its reportable segments and concluded that, although certain structural changes were made to reflect this reorganization on October 1, 2004, Nortel did not meet the criteria to change its reportable segments under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, for the fiscal year 2004. Nortel’s operating results on a segmented basis for the new business organizations were not available for review by the chief operating decision maker (“CODM”), as a significant amount of Nortel’s finance resources were allocated to the restatement activity. Nortel is currently reviewing the impact of these changes on its 2005 reportable segments.
 
    Nortel’s chief executive officer (the “CEO”) has been identified as the CODM in assessing the performance of the segments and the allocation of resources to the segments. In 2004, each reportable segment was managed separately with each segment manager reporting directly or indirectly to the CEO. The CEO relies on the information derived directly from Nortel’s management reporting system. Commencing in the second quarter of 2004, in conjunction with the appointment of William A. Owens, as Nortel’s president and chief executive officer, the primary financial measure used by the CEO in assessing performance and allocating resources to the segments is management earnings (loss) before income taxes (“Management EBT”), a measure that includes the cost of revenues and SG&A expense, research and development (“R&D”) expense, interest expense, other income (expense) — net, minority interests — net of tax and equity in net loss of associated companies — net of tax. This primary financial measure replaced contribution margin, the previously disclosed primary financial measure used for earlier periods. Contribution margin differs from Management EBT in that it excludes R&D expense, interest expense, other income (expense) — net, minority interests — net of tax and equity in net loss of associated companies — net of tax.
 
    Costs associated with shared services and other corporate costs are allocated to the segments based on usage determined generally by headcount. Costs not allocated to the segments are primarily related to Nortel’s corporate compliance and other non-operational activities and are included in “other”. In addition, the CEO does not review asset information on a segmented basis in order to assess performance and allocate resources. The accounting policies of the reportable segments are the same as those applied to the consolidated financial statements.

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    Segments
 
    The following tables set forth information by segment for each of the three and nine months ended September 30:
                                 
 
    Three months ended September 30,
    Nine months ended September 30,
 
    2004     2003     2004     2003  

 
Revenues
                               
Wireless Networks
  $ 1,054     $ 1,111     $ 3,560     $ 2,953  
Enterprise Networks
    591       545       1,703       1,650  
Wireline Networks
    379       423       1,262       1,433  
Optical Networks
    155       260       680       865  
Other
          5       8       26  

 
Total
  $ 2,179     $ 2,344     $ 7,213     $ 6,927  

 
Management EBT
                               
Wireless Networks
  $ (36 )   $ 215     $ 353     $ 377  
Enterprise Networks
    39       21       78       37  
Wireline Networks
    (56 )     (3 )     (72 )     91  
Optical Networks
    (73 )     5       (159 )     (156 )
Other
    (112 )     (18 )     (436 )     (286 )

 
Total
    (238 )     220       (236 )     63  

 
Amortization of acquired technology and other
    (2 )     (32 )     (7 )     (98 )
Deferred stock option compensation
          (1 )           (16 )
Special charges
    (93 )     (80 )     (99 )     (198 )
Gain (loss) on sale of businesses and assets
    39       17       114       6  
Income tax benefit (expense)
    30       (36 )     32       4  

 
Net earnings (loss) from continuing operations
  $ (264 )   $ 88     $ (196 )   $ (239 )

 

6.   Special charges
 
    During 2001, Nortel implemented a work plan to streamline operations and activities around core markets and leadership strategies in light of the significant downturn in both the telecommunications industry and the economic environment, and capital market trends impacting operations and expected future growth rates (the “2001 Restructuring Plan”).
 
    In addition, activities were initiated in 2003 to exit certain leased facilities and leases for assets no longer used across all segments. The liabilities associated with these activities were measured at fair value and recognized under SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”).
 
    In 2004 and into 2005, Nortel’s focus is on managing each of its businesses based on financial performance, the market and customer priorities. In the third quarter of 2004, Nortel announced a strategic plan that includes a work plan involving focused workforce reductions, including a voluntary retirement program, of approximately 3,250 employees, real estate optimization and other cost containment actions such as reductions in information services costs, outsourced services and other discretionary spending across all segments, but primarily in Wireline Networks and Optical Networks (the “2004 Restructuring Plan”).
 
    During the three and nine months ended September 30, 2004, Nortel continued to implement these restructuring work plans. Special charges recorded from January 1, 2004 to September 30, 2004 were as follows:

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            Contract              
            settlement     Plant and        
    Workforce     and lease     equipment        
    reduction     costs     write downs     Total  

 
2001 Restructuring Plan
                               
Provision balance as of December 31, 2003
  $ 64     $ 456     $     $ 520  
Other special charges:
                               
For the three months ended March 31, 2004
    6                   6  
For the three months ended June 30, 2004
                       
For the three months ended September 30, 2004
                       
Revisions to prior accruals:
                               
For the three months ended March 31, 2004
          1             1  
For the three months ended June 30, 2004
          (1 )           (1 )
For the three months ended September 30, 2004
    (4 )     24       1       21  
Cumulative provision (drawdowns) adjustments in 2004:
                               
Cash drawdowns
    (45 )     (133 )           (178 )
Non-cash drawdowns
                (1 )     (1 )
Foreign exchange and other adjustments
    (4 )     14             10  

 
Provision balance as of September 30, 2004
  $ 17     $ 361     $     $ 378  

 
2004 Restructuring Plan
                               
Provision balance as of December 31, 2003
  $     $     $     $  
Other special charges:
                               
For the three months ended September 30, 2004
    72                   72  

 
Provision balance as of September 30, 2004
  $ 72     $     $     $ 72  

 

 
Provision balance as of September 30, 2004 (a)
  $ 89     $ 361     $     $ 450  

 
  (a)   As of September 30, 2004 and December 31, 2003, the short-term provision balance was $190 and $206, respectively, and the long-term provision balance was $260 and $314.

    Three and nine months ended September 30, 2004
 
    During the three and nine months ended September 30, 2004, Nortel recorded special charges of $21 and $27, respectively, related to the 2001 Restructuring Plan which included revisions of $21 and $21, respectively, related to prior accruals.
 
    Workforce reduction charges of $6 were related to severance and benefit costs associated with approximately 80 employees notified of termination during the three months ended March 31, 2004, which related entirely to Optical Networks, and were partially offset by revision to prior accruals in the third quarter of 2004 of $4. During the nine months ended September 30, 2004, the workforce reduction provision balance was drawn down by cash payments of $45. The remaining provision is expected to be substantially drawn down by the end of 2005.
 
    No new contract settlement and lease costs were incurred during the period. Net revisions to prior accruals for contract settlement and lease costs of $24 were identified for the nine months ended September 30, 2004. During the nine months ended September 30, 2004, the provision balance for contract settlement and lease costs was drawn down by cash payments of $133. The remaining provision, net of approximately $270 in estimated sublease income, is expected to be substantially drawn down by the end of 2013.
 
    The table below summarizes the total costs estimated to be incurred as a result of the exit activities initiated in 2003, which have met the criteria described in SFAS 146, the balance of these accrued expenses as of September 30, 2004 and the movement in the accrual for the nine months ended September 30, 2004. These costs are included in the provision balance above for the 2001 Restructuring Plan as of September 30, 2004.

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            Costs     Payments     Adjustments        
    Accrued     incurred     made     made        
    balance as     during the     during the     during the     Accrued  
    of December 31,     nine months ended     nine months ended     nine months ended     balance as at  
    2003     September 30, 2004     September 30, 2004     September 30, 2004     September 30, 2004
 
Lease costs (a)
  $ 36     $     $ (10 )   $ 7     $ 33  

 
  (a)   Total estimated costs, net of estimated sublease income, associated with these accruals are $69, of which $14 was drawn down by cash payments of $8 and non-cash adjustments of $6 prior to January 1, 2004.

    Regular full-time (“RFT”) employee notifications included in special charges under the 2001 Restructuring Plan were as follows:
                         
 
    Employees (approximate)
 
    Direct (a)     Indirect (b)     Total  

 
RFT employee notifications for the three months ended
                       
March 31, 2004
    40       40       80  

 
  (a)   Direct employees included employees performing manufacturing, assembly, test and inspection activities associated with the production of Nortel’s products.
  (b)   Indirect employees included employees performing manufacturing, management, sales, marketing, research and development and administrative activities.

    During the three months ended September 30, 2004, Nortel recorded special charges of $72 related to the 2004 Restructuring Plan.
 
    Workforce reduction charges of $72 were related to severance and benefit costs associated with approximately 1,300 employees identified for termination under ongoing benefit arrangements. The workforce reduction was primarily in the U.S., Canada, and EMEA and extended across all segments but primarily in Wireline Networks and Optical Networks. During the three months ended September 30, 2004, the workforce reduction provision balance had not been drawn down by any cash payments. The remaining provision is expected to be substantially drawn down by the end of 2005.
 
    Nortel estimates charges to earnings associated with the 2004 Restructuring Plan in the aggregate of approximately $450 comprised of approximately $220 with respect to the workforce reductions and approximately $230 with respect to the real estate actions. No charges are expected to be recorded with respect to the other cost containment actions. Approximately one-third of the aggregate charges were incurred in 2004 with the remainder expected to be incurred in 2005.
 
    Three and nine months ended September 30, 2003
 
    For the three and nine months ended September 30, 2003, Nortel recorded total special charges of $80 and $198, respectively, related to the 2001 Restructuring Plan which was net of revisions of $14 and $103 related to prior accruals.
 
    Workforce reduction charges of $170 in the nine months ended September 30, 2003 were related to severance and benefit costs, including a pension settlement loss of $47, associated with approximately 1,300 employees notified of termination during the nine months ended September 30, 2003, which extended across all segments. Offsetting these charges were net revisions of $35, which were primarily related to termination benefits where actual costs were lower than the estimated amounts across all segments.
 
    Contract settlement and lease costs of $63 in the nine months ended September 30, 2003 consisted of net lease charges related to leased facilities (comprised of office, warehouse and manufacturing space) and leased furniture that were newly identified as no longer being used. Offsetting these charges were revisions of $40 resulting from changes in estimates for sublease income and costs to vacate certain properties which extended across all segments.
 
    Plant and equipment charges of $68 in the nine months ended September 30, 2003 were related to current period write downs to fair value less costs to sell for various leasehold improvements and excess Optical Networks equipment.

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    Offsetting these charges were revisions of $28 to prior write downs of assets held for sale related primarily to adjustments to original plans or estimated amounts for certain facility closures.
 
7.   Income taxes
 
    During the nine months ended September 30, 2004, Nortel recorded a tax benefit of $32 on a loss from continuing operations before income taxes, minority interests and equity in net loss of associated companies of $197. Nortel recorded a tax expense against the earnings of certain taxable entities and recorded additional valuation allowances against the tax benefit of current period losses of other entities. The tax benefit of $32 is primarily a result of R&D related incentives and the benefit of favourable audit settlements, partially offset by tax expense recorded against the earnings of certain taxable entities and corporate minimum and other taxes.
 
    During the nine months ended September 30, 2003, Nortel recorded a tax benefit of $4 on a loss from continuing operations before income taxes, minority interests and equity in net loss of associated companies of $153. Nortel recorded a tax expense against the earnings of certain taxable entities and recorded additional valuation allowances against the tax benefit of current period losses of other entities. The tax benefit of $4 is primarily a result of R&D related incentives and the drawdown of the deferred tax liability to acquired technology, partially offset by tax expense recorded against earnings of certain taxable entities, corporate minimum and other taxes.
 
    As of September 30, 2004, Nortel’s deferred income tax assets, excluding discontinued operations, were $3,669. The deferred income tax assets are net of a valuation allowance of $3,455. The most significant components of the gross deferred income tax assets are the tax benefit of loss carryforwards and investment tax credits and temporary differences related to certain liabilities (primarily provisions, pensions and other post retirement obligations). Although a certain portion of carryforward amounts have begun to expire in 2004, the majority do not begin to expire until 2017.
 
    The valuation allowance of $3,455 was recorded in accordance with SFAS No. 109, “Accounting for Income Taxes”, which requires that a valuation allowance be established when it is more likely than not that some portion or all of a company’s deferred tax assets will not be realized. The valuation allowances were determined based on an assessment of the positive and negative evidence, which included the carryforward periods attributable to the significant tax assets, Nortel’s history of generating taxable income in its material jurisdictions, and Nortel’s cumulative loss position. Primarily as a result of the losses realized in 2001 and 2002, Nortel determined that it is not more likely than not that a portion of its deferred income tax assets will be realized. Accordingly, a valuation allowance has been recorded against a portion of the assets. However, due to the fact that the majority of the carryforward amounts do not expire in the near future, Nortel’s extended history of profitability in its material tax jurisdictions, exclusive of the 2001 and 2002 losses, and Nortel’s future projections of profitability, Nortel determined that it is more likely than not that the remaining portion of its deferred income tax assets recorded at September 30, 2004 will be realized.
 
    Nortel is subject to ongoing examinations by certain tax authorities of the jurisdictions in which it operates. Nortel regularly assesses the status of these examinations and the potential for adverse outcomes to determine the adequacy of the provision for income and other taxes. Nortel believes that it has adequately provided for tax adjustments that are probable as a result of any ongoing or future examinations.
 
8.   Employee benefit plans
 
    Nortel maintains various retirement programs covering substantially all of its employees, consisting of defined benefit, defined contribution and investment plans.
 
    Nortel has four kinds of capital accumulation and retirement programs: balanced capital accumulation and retirement programs (the “Balanced Program”) and investor capital accumulation and retirement programs (the “Investor Program”) available to substantially all of its North American employees; flexible benefits plan, which includes a group personal pension plan (the “Flexible Benefits Plan”), available to substantially all of its employees in the U.K.; and traditional capital accumulation and retirement programs that include defined benefit pension plans (the “Traditional Program”) which are closed to new entrants in the U.K. and portions of which are closed to new entrants in the U.S. and Canada. Although these four kinds of programs represent Nortel’s major retirement programs and may be available to employees in combination and/or as options within a program, Nortel also has smaller pension plan arrangements in other countries.
 
    Nortel also provides other benefits, including post-retirement benefits and post-employment benefits. Employees in the Traditional Program are eligible for their existing company sponsored post-retirement benefits or a modified version of these benefits, depending on age or years of service. Employees in the Balanced Program are eligible for post-retirement benefits at reduced company contribution

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    levels, while employees in the Investor Program have access to post-retirement benefits by purchasing a Nortel-sponsored retiree health care plan at their own cost.
 
    The following details the net pension expense for the defined benefit plans for the three and nine months ended September 30:
                                 
 
    Three months ended September 30,
    Nine months ended September 30,
 
    2004     2003     2004     2003  

 
Pension expense:
                               
Service cost
  $ 30     $ 30     $ 90     $ 89  
Interest cost
    104       99       311       306  
Expected return on plan assets
    (102 )     (96 )     (305 )     (307 )
Amortization of prior service cost
    1       4       3       8  
Amortization of net losses (gains)
    19       11       57       34  
Settlement losses (gains)
          49             52  

 
Net pension expense
  $ 52     $ 97     $ 156     $ 182  

 

    The following details the net cost components, all related to continuing operations, of post-retirement benefits other than pensions for the three and nine months ended September 30:
                                 
 
    Three months ended September 30,
    Nine months ended September 30,
 
    2004     2003     2004     2003  

 
Post-retirement benefit cost:
                               
Service cost
  $ 2     $ 2     $ 7     $ 7  
Interest cost
    10       11       30       31  
Expected return on plan assets
                      (2 )
Amortization of prior service cost
                (2 )     (2 )
Amortization of net losses (gains)
                2        

 
Net post-retirement benefit cost
  $ 12     $ 13     $ 37     $ 34  

 

    During the nine months ended September 30, 2004, contributions of $167 were made to the defined benefit plans and $23 to the post-retirement benefit plans. Nortel contributed an additional $35 in 2004 to the defined benefit plans for a total contribution of $202, which excluded $78 of deferred contributions for 2004 which were made in 2003, and an additional $8 in 2004 to the post-retirement benefit plans for a total contribution of $31.
 
    On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “MPDIM Act”) was signed into law in the U.S. The MPDIM Act introduced a prescription drug benefit under Medicare (specifically, Medicare Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. As permitted by FSP FAS 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003”, Nortel chose to make the one-time deferral election which remained in effect for its plans in the U.S. until the earlier of the issuance of specific authoritative guidance by the FASB on how to account for the federal subsidy to be provided to plan sponsors under the MPDIM Act or the remeasurement of plan assets and obligations subsequent to January 31, 2004. On May 19, 2004, FSP FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP FAS 106-2”) was issued by the FASB to provide guidance relating to the prescription drug subsidy provided by the MPDIM Act. Nortel expects to have portions of its post-retirement benefit plans qualify as actuarially equivalent to the benefit provided under the MPDIM Act, for which it expects to receive federal subsidies. Nortel expects that other portions of the plans will not be actuarially equivalent. Nortel adopted FSP FAS 106-2 in the second quarter of 2004. The financial impact of the federal subsidies was determined by remeasuring Nortel retiree life and medical obligation as of January 1, 2004, as provided under the retroactive application provision of FSP FAS 106-2. As a result of adoption, the accumulated post-retirement benefit obligation decreased by $31. Net periodic post-retirement benefit costs decreased by $1 and $2 for the three and nine months ended September 30, 2004.

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9.   Acquisitions and divestitures
 
    Acquisitions
 
    On July 1, 2003, European Aeronautic Defence and Space Company EADS N.V. (“EADS”) exercised a put option to sell its minority interest of 45 percent in Nortel Networks France S.A.S. (“NNF”) to Nortel. On July 18, 2003, Nortel exercised its call option and share exchange rights to acquire the minority interest held by EADS of 42 percent in Nortel Networks Germany GmbH & Co. KG (“NNG”) and to sell Nortel’s equity interest of 41 percent in EADS Telecom S.A.S., formerly EADS Defence and Security Networks S.A.S (“EADS Telecom”) to EADS. The transactions were completed on September 18, 2003.
 
    During the three months ended September 30, 2003, Nortel recorded the acquisitions of the minority interests of NNF and NNG based on preliminary valuation estimates totaling $241. The purchase price of $241 included $58 of cash, an in-kind component of approximately $82 representing the return of a loan note that was owed to Nortel by EADS Telecom and the remaining shares of EADS Telecom held by Nortel. The allocation of the purchase price resulted in the elimination of $23 of minority interest, settlement of a net liability of $94 related to the put and call options and an increase of $45 in intangible assets and $79 in goodwill. The intangible assets of $45 related primarily to customer contracts and customer relationships and are being amortized based on their expected pattern of benefit to future periods using estimates of undiscounted cash flows, and were included in intangible assets on the consolidated balance sheet as of December 31, 2003.
 
    The sale of Nortel’s 41 percent interest in EADS Telecom resulted in the receipt of cash of $12 and a reduction in equity investments of $23. As a result of this transaction, Nortel recognized a gain of $79 which is included in other income (expense) — net for the nine months ended September 30, 2003. Except as noted below, there was no additional impact on the results of operations and financial condition, as NNF and NNG were already included in the consolidated results.
 
    Divestitures
 
    On February 3, 2004, Nortel sold approximately 7 million common shares of Entrust Inc. (“Entrust”) for cash consideration of $33, and recorded a gain of $18 in other income (expense) — net. As a result of this transaction, Nortel no longer holds any equity interest in Entrust.
 
    During March 2004, Nortel sold 1.8 million shares of Arris Group, Inc. (“Arris Group”) for cash consideration of $17, which resulted in a gain of $13, which was recorded in other income (expense) — net. Following this transaction, Nortel owned 3.2 million Arris Group common shares or 4.2 percent of Arris Group outstanding common shares (see note 18).
 
    On May 7, 2004, Nortel received $80 in proceeds from the sale of certain assets in connection with a customer contract settlement in Latin America. This resulted in a gain of $78, which was included in (gain) loss on sale of businesses and assets for the nine months ended September 30, 2004.
 
    On August 2, 2004, Nortel completed the contribution of certain fixed assets, intangible assets including customer contracts, software and other licenses, and liabilities of its directory and operator services (“DOS”) business to VoltDelta Resources LLC (“VoltDelta”), a wholly owned subsidiary of Volt Information Sciences, Inc. (“VIS”), in return for a 24 percent interest in VoltDelta which was valued at $55. After a period of two years, Nortel and VIS each have an option to cause Nortel to sell its VoltDelta shares to VIS for proceeds ranging from $25 to $70. As a result of this transaction, approximately 160 Nortel DOS employees in North America and Mexico joined VoltDelta. Nortel recorded a gain on sale of businesses and assets of approximately $38 in the third quarter of 2004.
 
10.   Long-term debt, credit and support facilities
 
    Long-term debt
 
    As a result of the delay in the filing of the Nortel 2003 Annual Report and the annual report on Form 10-K for the year ended December 31, 2003 of Nortel’s principal operating subsidiary, NNL (the “NNL 2003 Annual Report”, and together with the Nortel 2003 Annual Report, the “2003 Annual Reports”), and as a result of the delay in the filing of Nortel’s and NNL’s quarterly reports on Form 10-Q for the three months ended March 31, 2004 (the “First Quarter Reports”), the three months ended June 30, 2004 (the “Second Quarter Reports”) and the three months ended September 30, 2004 (the “Third Quarter Reports”, and together with the First Quarter Reports and

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    the Second Quarter Reports, the “Quarterly Reports” and the Quarterly Reports together with the 2003 Annual Reports, the “Reports”), Nortel and NNL were not in compliance with their obligations to deliver their respective SEC filings to the trustees under Nortel and NNL’s public debt indentures as of September 30, 2004. Although Nortel and NNL have now filed the 2003 Annual Reports and the Quarterly Reports, as a result of the delay in the filing of Nortel’s and NNL’s respective annual reports on Form 10-K for the year ended December 31, 2004 (the “2004 Annual Reports”), Nortel and NNL remain not in compliance with their obligation to deliver their respective SEC filings to the trustees under Nortel’s and NNL’s public debt indentures. Approximately $1,800 of notes of NNL (or its subsidiaries) and $1,800 of convertible debt securities of Nortel were outstanding under such indentures as of September 30, 2004. The continued delay in filing does not result in an automatic event of default and acceleration of the long-term debt of Nortel or NNL and such default and acceleration could not occur unless notice of such non-compliance is provided to Nortel or NNL, as applicable, and Nortel or NNL, as applicable, fail to file and deliver the 2004 Annual Reports within 90 days after such notice is provided, all in accordance with the terms of the indentures. Neither Nortel nor NNL has received any such notice as of September 30, 2004. For additional information, see note 20.
 
    During the nine months ended September 30, 2004, Nortel purchased land and two buildings for $87 that were previously leased by Nortel, through a single transaction variable interest entity that was consolidated under the provisions of FIN 46R. As a result, Nortel extinguished a debt of $87.
 
    During the nine months ended September 30, 2003, Nortel purchased a portion of its 6.125% Notes due February 15, 2006 with a face value of $39. The transaction resulted in a gain of $4 which was included in the consolidated statement of operations within other income (expense) — net for the nine months ended September 30, 2003.
 
    Credit facilities
 
    On April 28, 2004, NNL notified the banks under the NNL and Nortel Networks Inc. (“NNI”) $750 April 2000 five year credit facilities (the “Five Year Facilities”) that it was terminating these facilities. Absent such termination, the banks would have been permitted to terminate their commitments under the Five Year Facilities as a result of NNL’s inability to file the NNL 2003 Annual Report by April 29, 2004. Upon termination, the Five Year Facilities were undrawn. For information relating to the impact of the termination of the Five Year Facilities under the security agreements entered into by NNL and various of its subsidiaries, see note 22.
 
    Support facility
 
    On February 14, 2003, NNL entered into an agreement with Export Development Canada (“EDC”) regarding arrangements to provide for support, on a secured basis, of certain performance related obligations arising out of normal course business activities for the benefit of Nortel (the “EDC Support Facility”). NNL’s obligations under the EDC Support Facility also became secured on an equal and ratable basis under the security agreements entered into by NNL and various of its subsidiaries that pledged substantially all of the assets of NNL in favor of the banks under the Five Year Facilities and the holders of Nortel public debt securities. This security became effective in favor of the banks and the public debt holders on April 4, 2002 (see note 22). On July 10, 2003, NNL and EDC amended the terms of the EDC Support Facility by extending the termination date of the facility to December 31, 2005 from June 30, 2004 and on December 10, 2004, NNL and EDC amended the terms of the EDC Support Facility by extending the termination date of the facility to December 31, 2006 from December 31, 2005 (for additional information relating to the EDC Support Facility, the Five Year Facilities and the related security agreements, see notes 20 and 22).
 
    On March 10, 2004, Nortel announced that the filing of the 2003 Annual Reports with the SEC would be delayed. On March 15, 2004, Nortel announced that the filing of the 2003 Annual Reports with the SEC would extend beyond March 30, 2004 and that would result in EDC having the right to terminate its commitments under the EDC Support Facility and to exercise certain rights against the collateral under the related security agreements (see note 22). NNL obtained a waiver from EDC on March 29, 2004 of certain defaults under the EDC Support Facility related to the delay in filing the 2003 Annual Reports with the SEC, the trustees under Nortel’s and NNL’s public trust indentures and EDC and to permit continued access to the EDC Support Facility in accordance with its terms while Nortel and NNL completed their filing obligations. The waiver also applied to certain related breaches under the EDC Support Facility relating to the delayed filings and the planned restatements and revisions to Nortel’s and NNL’s prior financial results (the “Related Breaches”). The waiver was to remain in effect until the earliest of certain events or May 29, 2004. On March 29, 2004, NNL and EDC also amended the EDC Support Facility to provide that EDC may also suspend its obligation to issue NNL any additional support if events occur that have a material adverse effect on NNL’s business, financial position or results of operations and that such amendment would survive the waiver period.

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    On May 28, 2004, NNL obtained a new waiver from EDC of certain defaults under the EDC Support Facility related to the delay in filing the 2003 Annual Reports and the First Quarter Reports which waiver was to remain in effect until the earliest of certain events or August 30, 2004. This waiver reclassified the previously committed $300 revolving small bond sub-facility of the EDC Support Facility as uncommitted support.
 
    A further waiver was obtained from EDC effective August 20, 2004 (the “August Waiver”) related to the delay in filing the 2003 Annual Reports, the First Quarter Reports, the Second Quarter Reports and to the Related Breaches, which waiver was to remain in effect until the earliest of certain events or September 30, 2004.
 
    On September 29, 2004, NNL obtained a new waiver from EDC (the “September Waiver”) which replaced the August Waiver on substantially the same terms as provided in the August Waiver except that the September Waiver was to remain in effect until the earliest of certain events or October 31, 2004. For additional information relating to the EDC Support Facility, the waiver and the related security agreements, see notes 20 and 22.
 
    As of September 30, 2004, the EDC Support Facility provided for up to $750 in support including $300 of uncommitted revolving support for performance bonds or similar instruments, of which $201 was utilized, $150 of uncommitted support for receivables sales and/or securitizations, of which none was utilized, and $300 of uncommitted support for performance bonds and/or receivables sales and/or securitizations, of which $207 was utilized.
 
11.   Financial instruments and hedging activities
 
    On January 27, 2003, various cross currency coupon swaps (notional amount of Canadian $350) were terminated. There was no impact to net earnings (loss) on termination as these instruments were not designated as hedges and changes in fair value were previously accounted for in the consolidated statements of operations.
 
    Hedge ineffectiveness and the discontinuance of cash flow hedges and fair value hedges that were accounted for in accordance with SFAS 133 had no material impact on the net earnings (loss) for the nine months ended September 30, 2004 and 2003 and were reported within other income (expense) — net in the consolidated statements of operations.
 
12.   Guarantees
 
    Nortel has entered into agreements that contain features which meet the definition of a guarantee under FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others — An Interpretation of FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 34” (“FIN 45”). FIN 45 defines a guarantee as a contract that contingently requires Nortel to make payments (either in cash, financial instruments, other assets, common shares of Nortel Networks Corporation or through the provision of services) to a third party based on changes in an underlying economic characteristic (such as interest rates or market value) that is related to an asset, a liability or an equity security of the guaranteed party or a third party’s failure to perform under a specified agreement. A description of the major types of Nortel outstanding guarantees as of September 30, 2004 is provided below:

  (a)   Business sale and business combination agreements
 
      In connection with agreements for the sale of portions of its business, including certain discontinued operations, Nortel has typically retained the liabilities of a business which relate to events occurring prior to its sale, such as tax, environmental, litigation and employment matters. Nortel generally indemnifies the purchaser of a Nortel business in the event that a third party asserts a claim against the purchaser that relates to a liability retained by Nortel. Some of these types of guarantees have indefinite terms while others have specific terms extending to June 2008.
 
      Nortel also entered into guarantees related to the escrow of shares in business combinations in prior periods. These types of agreements generally include indemnities that require Nortel to indemnify counterparties for loss incurred from litigation that may be suffered by counterparties arising under such agreements. These types of indemnities apply over a specified period of time from the date of the business combinations and do not provide for any limit on the maximum potential amount.
 
      Nortel is unable to estimate the maximum potential liability for these types of indemnification guarantees as the business sale agreements generally do not specify a maximum amount and the amounts are dependent upon the outcome of future contingent events, the nature and likelihood of which cannot be determined.

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      Historically, Nortel has not made any significant indemnification payments under such agreements and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees.
 
      In conjunction with the sale of a subsidiary to a third party, Nortel guaranteed to the purchaser that specified annual volume levels would be achieved by the business sold over a ten year period ending December 31, 2007. The maximum amount that Nortel may be required to pay under the volume guarantee as of September 30, 2004 is $8. A liability of $8 has been accrued in the consolidated financial statements with respect to the obligation associated with this guarantee as of September 30, 2004.
 
  (b)   Intellectual property indemnification obligations
 
      Nortel has periodically entered into agreements with customers and suppliers that include limited intellectual property indemnification obligations that are customary in the industry. These types of guarantees typically have indefinite terms and generally require Nortel to compensate the other party for certain damages and costs incurred as a result of third party intellectual property claims arising from these transactions.
 
      The nature of the intellectual property indemnification obligations generally prevents Nortel from making a reasonable estimate of the maximum potential amount it could be required to pay to its customers and suppliers. Historically, Nortel has not made any significant indemnification payments under such agreements. A liability of $6 has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees as of September 30, 2004.
 
  (c)   Lease agreements
 
      Nortel has entered into agreements with its lessors that guarantee the lease payments of certain assignees of its facilities to lessors. Generally, these lease agreements relate to facilities Nortel vacated prior to the end of the term of its lease. These lease agreements require Nortel to make lease payments throughout the lease term if the assignee fails to make scheduled payments. Most of these lease agreements also require Nortel to pay for facility restoration costs at the end of the lease term if the assignee fails to do so. These lease agreements have expiration dates through June 2015. The maximum amount that Nortel may be required to pay under these types of agreements is $51 as of September 30, 2004. Nortel generally has the ability to attempt to recover such lease payments from the defaulting party through rights of subrogation.
 
      Historically, Nortel has not made any significant payments under these types of guarantees and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees.
 
  (d)   Third party debt agreements
 
      Nortel has guaranteed the debt of certain customers. These third party debt agreements require Nortel to make debt payments throughout the term of the related debt instrument if the customer fails to make scheduled debt payments. These third party debt agreements have expiration dates extending to May 2012. The maximum amount that Nortel may be required to pay under these types of debt agreements is $8 as of September 30, 2004. Under most such arrangements, the Nortel guarantee is secured, usually by the assets being purchased or financed. A liability of $8 has been accrued in the consolidated financial statements with respect to the obligations associated with these financial guarantees as of September 30, 2004.
 
  (e)   Indemnification under EDC Support Facility and security agreements
 
      As of September 30, 2004, Nortel had agreed to indemnify EDC under the EDC Support Facility against any legal action brought against EDC that relates to the provision of support under the EDC Support Facility. Nortel has also agreed to indemnify the collateral agent under the security agreements against any legal action brought against the collateral agent in connection with the collateral pledged under the security agreements. These indemnifications generally apply to issues that arise during the term of the support facilities or for as long as the security agreements remain in effect (see notes 10 and 20).

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      Nortel is unable to estimate the maximum potential liability for these types of indemnification guarantees as the agreements typically do not specify a maximum amount and the amounts are dependent upon the outcome of future contingent events, the nature and likelihood of which cannot be determined at this time.
 
      Historically, Nortel has not made any significant indemnification payments under such agreements and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these indemnification guarantees.
 
      Nortel has agreed to indemnify some of its counterparties in certain receivables securitization transactions. The indemnifications provided to counterparties in these types of transactions may require Nortel to compensate counterparties for costs incurred as a result of changes in laws and regulations (including tax legislation) or in the interpretations of such laws and regulations, or as a result of regulatory penalties that may be suffered by the counterparty as a consequence of the transaction. Certain receivables securitization transactions include indemnifications requiring the repurchase of the receivables if the particular transaction becomes invalid. As of September 30, 2004, Nortel had approximately $245 of securitized receivables which were subject to repurchase under this provision, in which case Nortel would assume all rights to collect such receivables. The indemnification provisions generally expire upon expiration of the securitization agreements, which extend through 2005, or collection of the receivable amounts by the counterparty.
 
      Nortel is generally unable to estimate the maximum potential liability for all of these types of indemnification guarantees as certain agreements do not specify a maximum amount and the amounts are dependent upon the outcome of future contingent events, the nature and likelihood of which cannot be determined at this time. Historically, Nortel has not made any significant indemnification payments or receivable repurchases under such agreements and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees.
 
  (f)   Other indemnification agreements
 
      Nortel has also entered into other agreements that provide indemnifications to counterparties in certain transactions including investment banking agreements, guarantees related to the administration of capital trust accounts, guarantees related to the administration of employee benefit plans, indentures for its outstanding public debt and asset sale agreements (other than the business sale agreements noted above). These indemnification agreements generally require Nortel to indemnify the counterparties for costs incurred as a result of changes in laws and regulations (including tax legislation) or in the interpretations of such laws and regulations and/or as a result of losses from litigation that may be suffered by the counterparties arising from the transactions. These types of indemnification agreements normally extend over an unspecified period of time from the date of the transaction and do not typically provide for any limit on the maximum potential payment amount.
 
      The nature of such agreements prevents Nortel from making a reasonable estimate of the maximum potential amount it could be required to pay to its counterparties. The difficulties in assessing the amount of liability result primarily from the unpredictability of future changes in laws, the inability to determine how laws apply to counterparties and the lack of limitations on the potential liability.
 
      Historically, Nortel has not made any significant indemnification payments under such agreements and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees.

    Product warranties
 
    As part of the normal sale of product, Nortel provides its customers with product warranties that extend for periods generally ranging from one to six years from the date of sale. The following summarizes the accrual for product warranties that was recorded as part of other accrued liabilities in the consolidated balance sheet as of September 30, 2004:

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Balance as of December 31, 2003
  $ 387  
Payments
    (232 )
Warranties issued
    170  
Revisions
    (20 )

 
Balance as of September 30, 2004
  $ 305  

 

13.   Commitments
 
    Bid, performance related and other bonds
 
    Nortel has entered into bid, performance related and other bonds associated with various contracts. Bid bonds generally have a term of less than twelve months, depending on the length of the bid period for the applicable contract. Performance related and other bonds generally have a term of twelve months and are typically renewed, as required, over the term of the applicable contract. The various contracts to which these bonds apply generally have terms ranging from two to five years. Any potential payments which might become due under these bonds would be related to Nortel’s non-performance under the applicable contract. Historically, Nortel has not had to make material payments under these types of bonds and does not anticipate that any material payments will be required in the future. The following table sets forth the maximum potential amount of future payments under bid, performance related and other bonds, net of the corresponding restricted cash and cash equivalents, as of the following periods:
                 
 
    September 30,     December 31,  
    2004     2003  

 
Bid and performance related bonds (a)
  $ 342     $ 427  
Other bonds (b)
    53       53  

 
Total bid, performance related and other bonds
  $ 395     $ 480  

 
  (a)   Net of restricted cash and cash equivalent amounts of $29 and $14 as of September 30, 2004 and December 31, 2003, respectively.
  (b)   Net of restricted cash and cash equivalent amounts of $32 and $31 as of September 30, 2004 and December 31, 2003, respectively.

    Customer financing
 
    Pursuant to certain financing agreements, Nortel is committed to provide future financing in connection with purchases of Nortel products and services. Commitments to extend future financing generally have conditions for funding, fixed expiration or termination dates and specific interest rates and purposes. Nortel attempts to limit its financing credit risk by utilizing an internal credit committee that monitors the credit exposure of Nortel. The following table sets forth customer financing related information and commitments, excluding discontinued operations, as of the following periods:
                 
 
    September 30,     December 31,  
    2004     2003  

 
Drawn and outstanding — gross
  $ 363     $ 401  
Provisions for doubtful accounts
    (271 )     (281 )

 
Drawn and outstanding — net (a)
    92       120  
Undrawn commitments (b)
    51       180  

 
Total customer financing
  $ 143     $ 300  

 
  (a)   Included short-term and long-term amounts. Short-term and long-term amounts were included in accounts receivable — net and other assets, respectively, in the consolidated balance sheets.
  (b)   On January 8, 2004, Nortel negotiated an agreement with a certain customer and reduced Nortel aggregate undrawn customer financing commitments from $180 to $69.

    During the nine months ended September 30, 2004 and 2003, Nortel recorded net customer financing bad debt recoveries of $11 and $77, respectively.
 
    During the nine months ended September 30, 2004 and 2003, Nortel entered into certain agreements to restructure and/or settle various customer financing and related receivables. As a result of these transactions, Nortel received cash consideration of approximately

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    $15 and $221, respectively, to settle outstanding receivables with a net carrying value of $14 and $117, respectively.
 
    During the nine months ended September 30, 2004 and 2003, Nortel reduced undrawn customer financing commitments by $129 and $712, respectively, as a result of the expiration or cancellation of commitments and changing customer business plans. As of September 30, 2004, all undrawn commitments were available for funding under the terms of the financing agreements.
 
    Venture capital financing
 
    Nortel has entered into agreements with selected venture capital firms where the venture capital firms make and manage investments in start-ups and emerging enterprises. The agreements require Nortel to fund requests for additional capital up to its commitments when and if requests for additional capital are solicited by the venture capital firm. Nortel had remaining commitments, if requested, of $17 and $24 as of September 30, 2004 and December 31, 2003, respectively. These commitments expire at various dates through 2012.
 
14.   Restricted cash and cash equivalents
 
    As of September 30, 2004 and December 31, 2003, approximately $77 and $63, respectively, of cash and cash equivalents was restricted as collateral for certain bid, performance related and other bonds as well as for certain normal course of business transactions. The cash and cash equivalents collateral was in addition to the payment of fees and was required as a result of the general economic and industry environment and NNL’s credit ratings.
 
15.   Capital stock and stock-based compensation plans
 
    Common shares
 
    Nortel Networks Corporation is authorized to issue an unlimited number of common shares without nominal or par value. The outstanding number of common shares and prepaid forward purchase contracts included in shareholders’ equity consisted of the following as of September 30, 2004:
                 
 
    September 30, 2004
 
    Number     $  

 
 
               
(Number of common shares in thousands)
               
 
               
Common shares:
               
Balance at beginning of the period
    4,166,714     $ 33,674  
Shares issued pursuant to:
               
Stock option plans
    7,127       39  
Acquisition and acquisition related (a)
    (3 )      
Prepaid forward purchase contracts (b)
    98,833       127  

 
Balance at end of the period
    4,272,671     $ 33,840  

 
 
               
(Number of prepaid forward purchase contracts)
               
 
               
Prepaid forward purchase contracts: (c)
               
Balance at beginning of the period
    9,693     $ 209  
Prepaid forward purchase contracts settled
    (5,853 )     (127 )

 
Balance at end of the period
    3,840     $ 82  

 
  (a)   Common shares issued as part of the purchase price consideration. During the nine months ended September 30, 2004, 3 common shares were cancelled as earn out provisions were forfeited pursuant to their applicable agreements.
  (b)   During the nine months ended September 30, 2004, 98,833 common shares were issued as a result of the early settlement of 5,853 prepaid forward purchase contracts. The net proceeds from the settled contracts of $127 were transferred from additional paid-in capital to common shares.
  (c)   Included in additional paid-in capital in the consolidated balance sheets.

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    At Nortel’s annual and special shareholders’ meeting on April 24, 2003, shareholders approved the reconfirmation and amendment of Nortel’s shareholder rights plan, which will expire at the annual meeting of shareholders to be held in 2006 unless it is reconfirmed at that time. Under the rights plan, Nortel issues one right for each Nortel Networks Corporation common share outstanding. These rights become exercisable upon the occurrence of certain events associated with an unsolicited takeover bid.
 
    Stock-based compensation plans
 
    As a result of Nortel’s March 10, 2004 announcements, as described in note 20, Nortel suspended as of March 10, 2004: the purchase of Nortel Networks Corporation common shares under the stock purchase plans for eligible employees in eligible countries that facilitate the acquisition of Nortel Networks Corporation common shares at a discount; the exercise of outstanding options granted under the Nortel Networks Corporation 2000 Stock Option Plan or Nortel Networks Corporation 1986 Stock Option Plan As Amended and Restated, or the grant of any additional options under those plans, or the exercise of outstanding options granted under employee stock option plans previously assumed by Nortel in connection with mergers and acquisitions; and the purchase of units in a Nortel stock fund or purchase of Nortel Networks Corporation common shares under Nortel’s defined contribution and investment plans, until such time, at the earliest, that Nortel and NNL are in compliance with U.S. and Canadian regulatory securities filing requirements.
 
    Due to the suspension of the purchase of Nortel Networks Corporation common shares under the stock purchase plans as discussed above, in lieu of the employer portion of stock purchase plan contributions Nortel made equivalent pre-tax payments to eligible employees during the three and nine months ended September 30, 2004 totaling $1 and $6, respectively, which was recorded as compensation expense in the respective periods.
 
16.   Earnings (loss) per common share
 
    The following table details the weighted-average number of Nortel Networks Corporation common shares outstanding for the purposes of computing basic and diluted earnings (loss) per common share for each of the three and nine months ended September 30:
                                 
 
    Three months ended September 30,
    Nine months ended September 30,
 
(Number of common shares in millions)   2004 (a)     2003     2004 (a)     2003 (a)  

 
Basic weighted-average shares outstanding:
                               
Issued and outstanding
    4,273       3,964       4,260       3,896  
Prepaid forward purchase contracts (b)
    65       366       76       433  

 
Basic weighted-average shares outstanding
    4,338       4,330       4,336       4,329  

 
Weighted-average shares dilution adjustments:
                               
Dilutive stock options
          2              

 
Diluted weighted-average shares outstanding
    4,338       4,332       4,336       4,329  

 
Weighted-average shares dilution adjustments — exclusions (a):
                               
Dilutive stock options
    300       296       300       298  
4.25% Convertible Senior Notes (c)
    180       180       180       180  

 
  (a)   As a result of the net loss from continuing operations for the three and nine months ended September 30, 2004 and nine months ended September 30, 2003, all potential dilutive securities were considered anti-dilutive.
  (b)   The impact of the minimum number of common shares to be issued upon settlement of the prepaid forward purchase contracts on a weighted-average basis was 65 and 76 for the three and nine months ended September 30, 2004, respectively, and 366 and 433 for the three and nine months ended September 30, 2003, respectively. As of September 30, 2004 and 2003, the minimum number of Nortel Networks Corporation common shares to be issued upon settlement of the prepaid forward purchase contracts was 65 and 333, respectively.
  (c)   The 4.25% Convertible Senior Notes were anti-dilutive for the three and nine months ended September 30, 2004 and 2003.

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17.   Comprehensive income (loss)
 
    The following are the components of comprehensive income (loss), net of tax, for the three and nine months ended September 30:
                                 
 
    Three months ended September 30,
    Nine months ended September 30,
 
    2004     2003     2004     2003  

 
Net earnings (loss)
  $ (259 )   $ 131     $ (184 )   $ (94 )
Other comprehensive income (loss) adjustments:
                               
Change in foreign currency translation adjustment (a)
    43       45       (29 )     340  
Unrealized gain (loss) on investments — net (b)
    (19 )     39       (79 )     83  
Minimum pension liability adjustment — net
                1        
Unrealized derivative gain (loss) on cash flow hedges — net (c)
    10       (8 )     (2 )     13  

 
Comprehensive income (loss)
  $ (225 )   $ 207     $ (293 )   $ 342  

 
  (a)   The change in the foreign currency translation adjustment was not adjusted for income taxes since it related to indefinite term investments in non-U.S. subsidiaries.
  (b)   Certain securities deemed available-for-sale by Nortel were measured at fair value. Unrealized holding gains (losses) related to these securities were excluded from net earnings (loss) and were included in accumulated other comprehensive loss until realized. Unrealized gain (loss) on investments was net of tax of nil and nil for the three months and nine months ended September 30, 2004, respectively, and net of tax of $(3) and nil for the three and nine months ended September 30, 2003, respectively.
  (c)   During the three and nine months ended September 30, 2004, $(1) and $1 of net derivative gains (losses) were reclassified to other income (expense) — net, respectively. During the three and nine months ended September 30, 2003, $7 and $21 of net derivative gains (losses) were reclassified to other income (expense) — net, respectively. Nortel estimates that $15 derivative gains (losses) included in accumulated other comprehensive loss will be reclassified into net earnings (loss) within the next 12 months.

18.   Discontinued operations
 
    During the year ended December 31, 2003, Nortel substantially completed the wind down of its access solutions operations. During the nine months ended September 30, 2004, there was no change to the initial disposal strategy or intent to exit the business which was approved by the Nortel Board of Directors on June 14, 2001.
 
    The following unaudited consolidated financial results for discontinued operations are presented for the three and nine months ended September 30, 2004 and 2003 for the consolidated statements of operations and as of September 30, 2004 and December 31, 2003 for the consolidated balance sheets and for the nine months ended September 30, 2004 and 2003 for the consolidated statements of cash flows:
 
    Consolidated statements of operations:
                                 

 
    Three months ended September 30,
    Nine months ended September 30,
 
    2004     2003     2004     2003  

 
Revenues
  $ 1     $ 2     $ 2     $ 9  
Net earnings (loss) from discontinued operations — net of tax (a)
  $ 5     $ 43     $ 12     $ 157  

 
  (a)   Net earnings (loss) from discontinued operations was net of applicable income tax of nil and nil for the three and nine months ended September 30, 2004, respectively, and net of applicable income tax of $19 and nil for the three and nine months ended September 30, 2003, respectively.

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    Consolidated balance sheets:
                 
 
    September 30,     December 31,  
    2004     2003  

 
Deferred income taxes
  $ 21     $ 26  
Other current assets
    (2)       2  

 
Total current assets of discontinued operations (a) (b)
  $ 19     $ 28  
 
               
Other long-term assets (b) (c)
    5       4  

 
Total assets of discontinued operations
  $ 24     $ 32  

 
Current liabilities (b) (d)
  $ 1     $ 6  
Long-term liabilities (b)
    1       1  

 
Total liabilities of discontinued operations
  $ 2     $ 7  

 
  (a)   Included accounts receivable of $(2) and nil, which was net of provisions of nil and $5, as of September 30, 2004 and December 31, 2003, respectively. Included inventories of nil and nil, which was net of provisions of $56 and $75, as of September 30, 2004 and December 31, 2003, respectively.
  (b)   Current assets, other long-term assets, current liabilities and long-term liabilities of discontinued operations were included in other current assets, other assets, other accrued liabilities and other liabilities, respectively, on the consolidated balance sheets.
  (c)   Included customer financing receivables of $4 and $4, which was net of provisions of $55 and $55, as of September 30, 2004 and December 31, 2003, respectively.
  (d)   Consisted of future contractual obligations and estimated liabilities of $1 and $6 as of September 30, 2004 and December 31, 2003, respectively.

    Consolidated statements of cash flows:
                 
 
    September 30,     September 30,  
    2004     2003  

 
Cash flows from (used in) discontinued operations
               
Operating activities
  $ 16     $ 148  
Investing activities
          241  

 
Net cash from (used in) discontinued operations
  $ 16     $ 389  

 

    Activity during the nine months ended September 30, 2003
 
    Nortel recorded net earnings from discontinued operations — net of tax, of $157 for the nine months ended September 30, 2003. The significant items included in net earnings are summarized below.
 
    During the nine months ended September 30, 2003, Nortel reassessed its remaining provisions for discontinued operations and recorded a net gain of $79, consisting of changes in estimates of $160 for liabilities, offset by additional provisions for both short-term and long-term receivables of $81.
 
    On March 24, 2003, Nortel sold 8 million common shares of Arris Group back to Arris Group for cash consideration of $28 pursuant to a March 11, 2003 agreement, which resulted in a gain of $12. Following this transaction, Nortel’s interest in Arris Group was reduced to 18.8 percent, and it ceased equity accounting for the investment. As a result, Nortel now classifies its remaining ownership interest in Arris Group as an available-for-sale investment within continuing operations. Nortel continues to dispose of its interest in Arris Group and the gain or loss on the sale of shares subsequent to the first quarter of 2003 has been included in other income (expense) — net (see note 9).
 
    On March 18, 2003, Nortel assigned its subordinated redeemable preferred interest in Arris Interactive, L.L.C. (“Arris Interactive”) to ANTEC Corporation, an Arris Group company, for cash consideration of $88. As a result of this transaction, Nortel recorded a loss of $2. Also in connection with the March 2003 transactions, Nortel received $11 upon settlement of a sales representation agreement with Arris Group and recorded a gain of $11.

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    On March 20, 2003, Nortel entered into an agreement with a customer to restructure approximately $465 of trade and customer financing receivables owed to Nortel, the majority of which was previously provisioned. As a result of the restructuring agreement, Nortel received consideration including cash of $125, notes receivable and an ownership interest which have been fully provided for and the mutual release of all other claims between the parties. A gain of $66 was recorded as a result of the transaction. In addition to the restructuring agreement, a five year equipment and services supply agreement was entered into requiring customer payment terms of either cash in advance or guarantee by letters of credit in favor of Nortel.
 
19.   Contingencies
 
    Subsequent to the February 15, 2001 announcement in which Nortel provided revised guidance for financial performance for the 2001 fiscal year and the first quarter of 2001, Nortel and certain of its then current officers and directors were named as defendants in more than twenty-five purported class action lawsuits. These lawsuits in the U.S. District Courts for the Eastern District of New York, for the Southern District of New York and for the District of New Jersey and the provinces of Ontario, Quebec and British Columbia in Canada, on behalf of shareholders who acquired Nortel Networks Corporation securities as early as October 24, 2000 and as late as February 15, 2001, allege, among other things, violations of U.S. federal and Canadian provincial securities laws. These matters also have been the subject of review by Canadian and U.S. securities regulatory authorities. On May 11, 2001, the defendants filed motions to dismiss and/or stay in connection with the three proceedings in Quebec primarily based on the factual allegations lacking substantial connection to Quebec and the inclusion of shareholders resident in Quebec in the class claimed in the Ontario lawsuit. The plaintiffs in two of these proceedings in Quebec obtained court approval for discontinuances of their proceedings on January 17, 2002. The motion to dismiss and/or stay the third proceeding was heard on November 6, 2001 and the court deferred any determination on the motion to the judge who will hear the application for authorization to commence a class proceeding. On December 6, 2001, the defendants filed a motion seeking leave to appeal that decision. The motion for leave to appeal was dismissed on March 11, 2002. On October 16, 2001, an order in the Southern District of New York was filed consolidating twenty-five of the related U.S. class action lawsuits into a single case, appointing class plaintiffs and counsel for such plaintiffs. The plaintiffs served a consolidated amended complaint on January 18, 2002. On December 17, 2001, the defendants in the British Columbia action served notice of a motion requesting the court to decline jurisdiction and to stay all proceedings on the grounds that British Columbia is an inappropriate forum. The motion has been adjourned at the plaintiffs’ request to a future date to be set by the parties.
 
    A class action lawsuit against Nortel was also filed in the U.S. District Court for the Southern District of New York on behalf of shareholders who acquired the securities of JDS between January 18, 2001 and February 15, 2001, alleging violations of the same U.S. federal securities laws as the above-noted lawsuits.
 
    On April 1, 2002, Nortel filed a motion to dismiss both the above consolidated U.S. shareholder class action and the above JDS shareholder class action complaints on the grounds that they failed to state a cause of action under U.S. federal securities laws. With respect to the JDS shareholder class action complaint, Nortel also moved to dismiss on the separate basis that JDS shareholders lacked standing to sue Nortel. On January 3, 2003, the District Court granted the motion to dismiss the JDS shareholder class action complaint and denied the motion to dismiss the consolidated U.S. class action complaint. Plaintiffs appealed the dismissal of the JDS shareholder class action complaint. On November 19, 2003, oral argument was held before the Second Circuit on the JDS shareholders’ appeal of the dismissal of their complaint. On May 19, 2004, the Second Circuit issued an opinion affirming the dismissal of the JDS shareholder class action complaint and on July 14, 2004 the Second Circuit denied plaintiffs’ motion for rehearing. On October 12, 2004, the plaintiffs filed a petition for writ of certiorari in the U.S. Supreme Court. On November 12, 2004, the defendants filed Brief for the Respondents in Opposition, and on November 22, 2004, the plaintiffs filed Reply to Brief in Opposition. On January 10, 2005, the U.S. Supreme Court denied the petition for writ of certiorari. With respect to the consolidated U.S. shareholder class action, the plaintiffs served a motion for class certification on March 21, 2003. On May 30, 2003, the defendants served an opposition to the motion for class certification. Plaintiffs’ reply was served on August 1, 2003. The District Court held oral arguments on September 3, 2003 and issued an order granting class certification on September 5, 2003. On September 23, 2003, the defendants filed a motion in the Second Circuit for permission to appeal the class certification decision. The plaintiffs’ opposition to the motion was filed on October 2, 2003. On November 24, 2003, the Second Circuit denied the motion. On March 10, 2004, the District Court approved the form of notice to the class which was published and mailed.
 
    On July 17, 2002, a new purported class action lawsuit (the “Ontario Claim”) was filed in the Ontario Superior Court of Justice, Commercial List, naming Nortel, certain of its current and former officers and directors and its auditors as defendants. The factual allegations in the Ontario Claim are substantially similar to the allegations in the consolidated amended complaint filed in the U.S. District Court described above. The Ontario Claim is on behalf of all Canadian residents who purchased Nortel Networks Corporation

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    securities (including options on Nortel Networks Corporation securities) between October 24, 2000 and February 15, 2001. The plaintiffs claim damages of Canadian $5,000, plus punitive damages in the amount of Canadian $1,000, prejudgment and postjudgment interest and costs of the action. On September 23, 2003, the Court issued an order allowing the plaintiffs to proceed to amend the Ontario Claim and requiring that the plaintiffs serve class certification materials by December 15, 2003. On September 24, 2003, the plaintiffs filed a notice of discontinuance of the original action filed in Ontario. On December 12, 2003, plaintiffs’ counsel requested an extension of time to January 21, 2004 to deliver class certification materials. On January 21, 2004, plaintiffs’ counsel advised the Court that the two representative plaintiffs in the action no longer wished to proceed, but counsel was prepared to deliver draft certification materials pending the replacement of the representative plaintiffs. On February 19, 2004, the plaintiffs’ counsel advised the Court of a potential new representative plaintiff. On February 26, 2004, the defendants requested the Court to direct the plaintiffs’ counsel to bring a motion to permit the withdrawal of the current representative plaintiffs and to substitute the proposed representative plaintiff. On June 8, 2004, the Court signed an order allowing a Second Fresh as Amended Statement of Claim that substituted one new representative plaintiff, but did not change the substance of the prior claim.
 
    A purported class action lawsuit was filed in the U.S. District Court for the Middle District of Tennessee on December 21, 2001, on behalf of participants and beneficiaries of the Nortel’s Long-Term Investment Plan (the “Plan”) at any time during the period of March 7, 2000 through the filing date and who made or maintained Plan investments in Nortel Networks Corporation common shares, under the Employee Retirement Income Security Act (“ERISA”) for Plan-wide relief and alleging, among other things, material misrepresentations and omissions to induce Plan participants to continue to invest in and maintain investments in Nortel Networks Corporation common shares in the Plan. A second purported class action lawsuit, on behalf of the Plan and Plan participants for whose individual accounts the Plan purchased Nortel Networks Corporation common shares during the period from October 27, 2000 to February 15, 2001 and making similar allegations was filed in the same court on March 12, 2002. A third purported class action lawsuit, on behalf of persons who are or were Plan participants or beneficiaries at any time since March 1, 1999 to the filing date and making similar allegations, was filed in the same court on March 21, 2002. The first and second purported class action lawsuits were consolidated by a new purported class action complaint, filed on May 15, 2002 in the same court and making similar allegations, on behalf of Plan participants and beneficiaries who directed the Plan to purchase or hold shares of certain funds, which held primarily Nortel Networks Corporation common shares, during the period from March 7, 2000 through December 21, 2001. On September 24, 2002, plaintiffs in the consolidated action filed a motion to consolidate all the actions and to transfer them to the U.S. District Court for the Southern District of New York. The plaintiffs then filed a motion to withdraw the pending motion to consolidate and transfer. The withdrawal was granted by the District Court on December 30, 2002. A fourth purported class action lawsuit, on behalf of the Plan and Plan participants for whose individual accounts the Plan held Nortel Networks Corporation common shares during the period from March 7, 2000 through March 31, 2001 and making similar allegations, was filed in the U.S. District Court for the Southern District of New York on March 12, 2003. On March 18, 2003, plaintiffs in the fourth purported class action filed a motion with the Judicial Panel on Multidistrict Litigation to transfer all the actions to the U.S. District Court for the Southern District of New York for coordinated or consolidated proceedings pursuant to 28 U.S.C. section 1407. On June 24, 2003, the Judicial Panel on Multidistrict Litigation issued a transfer order transferring the Southern District of New York action to the U.S. District Court for the Middle District of Tennessee (the “Consolidated ERISA Action”). On September 12, 2003, the plaintiffs in all the actions filed a consolidated class action complaint. On October 28, 2003, the defendants filed a motion to dismiss the complaint and a motion to stay discovery pending disposition of the motion to dismiss. On March 30, 2004, the plaintiffs filed a motion for certification of a class consisting of participants in, or beneficiaries of, the Plan who held shares of the Nortel Stock Fund during the period from March 7, 2000 through March 31, 2001. On April 27, 2004, the Court granted the defendants’ motion to stay discovery pending resolution of defendants’ motion to dismiss. On June 15, 2004, the plaintiffs filed a First Amended Consolidated Class Action Complaint that added additional current and former officers and employees as defendants and expanded the purported class period to extend from March 7, 2000 through to June 15, 2004.
 
    On March 4, 1997, Bay Networks, Inc. (“Bay Networks”), a company acquired on August 31, 1998, announced that shareholders had filed two separate lawsuits in the U.S. District Court for the Northern District of California (the “Federal Court”) and the California Superior Court, County of Santa Clara (the “California Court”), against Bay Networks and ten of Bay Networks’ then current and former officers and directors purportedly on behalf of a class of shareholders who purchased Bay Networks’ common shares during the period of May 1, 1995 through October 14, 1996. On August 17, 2000, the Federal Court granted the defendants’ motion to dismiss the federal complaint. On August 1, 2001, the U.S. Court of Appeals for the Ninth Circuit denied the plaintiffs’ appeal of that decision. On April 18, 1997, a second lawsuit was filed in the California Court, purportedly on behalf of a class of shareholders who acquired Bay Networks’ common shares pursuant to the registration statement and prospectus that became effective on November 15, 1995. The two actions in the California Court were consolidated in April 1998; however, the California Court denied the plaintiffs’ motion for class certification.

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    In January 2000, the California Court of Appeal rejected the plaintiffs’ appeal of the decision. A petition for review was filed with the California Supreme Court by the plaintiffs and was denied. In February 2000, new plaintiffs who allege to have been shareholders of Bay Networks during the relevant periods, filed a motion for intervention in the California Court seeking to become the representatives of a class of shareholders. The motion was granted on June 8, 2001 and the new plaintiffs filed their complaint-in-intervention on an individual and purported class representative basis alleging misrepresentations made in connection with the purchase and sale of securities of Bay Networks in violation of California statutory and common law. On March 11, 2002, the California Court granted the defendants’ motion to strike the class allegations. The plaintiffs were permitted to proceed on their individual claims. The intervenor-plaintiffs appealed the dismissal of their class allegations. On July 25, 2003, the California Court of Appeal reversed the trial court’s dismissal of the intervenor-plaintiffs’ class allegations. On September 3, 2003, the defendants filed a petition for review with the California Supreme Court seeking permission to appeal the Court of Appeal decision. On October 22, 2003, the California Supreme Court denied, without opinion, the defendants’ petition for review. On December 22, 2003, the plaintiffs served their motion for certification of a class of purchasers of Bay Networks’ common shares from July 25, 1995 through to October 14, 1996. Hearing of the plaintiffs’ motion for class certification was held on May 4, 2004. On July 27, 2004, the Court entered an Amended Order Denying Motion of Intervenor Plaintiffs for Class Certification and Setting Further Hearing. On August 9, 2004, the intervenor-plaintiffs obtained Court approval to dismiss their claims and this action and, on September 30, 2004, the Court entered dismissal with prejudice of the entire action of all parties and all causes of action.
 
    Subsequent to the March 10, 2004 announcement in which Nortel indicated it was likely that it would need to revise its previously announced unaudited results for the year ended December 31, 2003, and the results reported in certain of its quarterly reports for 2003, and to restate its previously filed financial results for one or more earlier periods, Nortel and certain of its then current and former officers and directors were named as defendants in 27 purported class action lawsuits. These lawsuits in the U.S. District Court for the Southern District of New York on behalf of shareholders who acquired Nortel Networks Corporation securities as early as February 16, 2001 and as late as May 15, 2004, allege, among other things, violations of U.S. federal securities laws. These matters are also the subject of investigations by Canadian and U.S. securities regulatory and criminal investigative authorities (see note 20). On June 30, 2004, the Court signed Orders consolidating the 27 class actions and appointing lead plaintiffs and lead counsel. The plaintiffs filed a consolidated class action complaint on September 10, 2004, alleging a class period of April 24, 2003 through and including April 27, 2004. On November 5, 2004, Nortel Networks Corporation and the Audit Committee Defendants filed a motion to dismiss the consolidated class action complaint. On January 18, 2005, the lead plaintiffs, Nortel Networks Corporation, and the Audit Committee Defendants reached an agreement in which Nortel would withdraw its motion to dismiss and plaintiffs would dismiss Count II of the complaint which asserts a claim against the Audit Committee Defendants.
 
    On May 18, 2004, a purported class action lawsuit was filed in the U.S. District Court for the Middle District of Tennessee on behalf of individuals who were participants and beneficiaries of the Plan at any time during the period of December 23, 2003 through the filing date and who made or maintained Plan investments in Nortel Networks Corporation common shares, under the ERISA for Plan-wide relief and alleging, among other things, breaches of fiduciary duty. On September 3, 2004, the Court signed a stipulated order consolidating this action with the Consolidated ERISA Action described above. On June 16, 2004, a second purported class action lawsuit, on behalf of the Plan and Plan participants for whose individual accounts the Plan purchased Nortel Networks Corporation common shares during the period from October 24, 2000 to June 16, 2004, and making similar allegations, was filed in the U.S. District Court for the Southern District of New York. On August 6, 2004, the Judicial Panel on Multidistrict Litigation issued a conditional transfer order to transfer this action to the U.S. District Court for the Middle District of Tennessee for coordinated or consolidated proceedings pursuant to 28 U.S.C. section 1407 with the Consolidated ERISA Action described above. On August 20, 2004, plaintiffs filed a notice of opposition to the conditional transfer order with the Judicial Panel. On December 6, 2004, the Judicial Panel denied the opposition and ordered the action transferred to the U.S. District Court for the Middle District of Tennessee for coordinated or consolidated proceedings with the Consolidated ERISA Action described above. On January 3, 2005, this action was received in the U.S. District Court for the Middle District of Tennessee and it has been consolidated with the Consolidated ERISA Action described above.
 
    On July 28, 2004, Nortel and NNL, and certain directors and officers, and certain former directors and officers, of Nortel and NNL, were named as defendants in a purported class proceeding in the Ontario Superior Court of Justice on behalf of shareholders who acquired Nortel Networks Corporation securities as early as November 12, 2002 and as late as July 28, 2004. This lawsuit alleges, among other things, breaches of trust and fiduciary duty, oppressive conduct and misappropriation of corporate assets and trust property in respect of the payment of cash bonuses to executives, officers and employees in 2003 and 2004 under the Nortel Return to Profitability bonus program and seeks damages of Canadian $250 and an order under the Canada Business Corporations Act directing that an

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    investigation be made respecting these bonus payments.
 
    On July 30, 2004, a shareholders’ derivative complaint was filed in the U.S. District Court for the Southern District of New York against certain directors and officers, and certain former directors and officers, of Nortel alleging, among other things, breach of fiduciary duties owed to Nortel during the period from 2000 to 2003 including by causing Nortel to engage in unlawful conduct or failing to prevent such conduct; causing Nortel to issue false statements; and violating the law. On February 14, 2005, the defendants filed a motion to dismiss the derivative complaint.
 
    On February 16, 2005, a motion for authorization to institute a class action on behalf of residents of Québec, who purchased Nortel securities between January 29, 2004 and March 15, 2004, was filed in the Québec Superior Court naming Nortel as a defendant. The factual allegations allege that Nortel made misrepresentations about its 2003 financial results.
 
    On March 9, 2005, Nortel and certain of its current and former officers and directors and its auditors were named as defendants in a purported class proceeding filed in the Ontario Superior Court of Justice, Commercial List, on behalf of all Canadian residents who purchased Nortel Networks Corporation securities from April 24, 2003 to April 27, 2004. This lawsuit alleges, among other things, negligence, misrepresentations, oppressive conduct, insider trading and violations of Canadian corporation and competition laws in connection with Nortel’s 2003 financial results and seeks damages of Canadian $3,000, plus punitive damages in the amount of Canadian $1,000, prejudgment and postjudgment interest and costs of the action.
 
    Except as otherwise described herein, in each of the matters described above, the plaintiffs are seeking an unspecified amount of monetary damages.
 
    Nortel is also a defendant in various other suits, claims, proceedings and investigations which arise in the normal course of business.
 
    Nortel is unable to ascertain the ultimate aggregate amount of monetary liability or financial impact to Nortel of the above matters which, unless otherwise specified, seek damages from the defendants of material or indeterminate amounts or could result in fines and penalties. Nortel cannot determine whether these actions, suits, claims and proceedings will, individually or collectively, have a material adverse effect on the business, results of operations, financial condition and liquidity of Nortel. Nortel and any named directors and officers of Nortel intend to vigorously defend these actions, suits, claims and proceedings.
 
    Environmental matters
 
    Nortel’s operations are subject to a wide range of environmental laws in various jurisdictions around the world. Nortel seeks to operate its business in compliance with such laws. In 2004, Nortel became subject to new European product content laws and product takeback and recycling requirements that will require full compliance by 2006. It is expected that these laws will require Nortel to incur additional compliance costs. Although costs relating to environmental matters have not resulted in a material adverse effect on the business, results of operations, financial condition and liquidity in the past, there can be no assurance that Nortel will not be required to incur such costs in the future. Nortel has a corporate environmental management system standard and an environmental program to promote such compliance. Moreover, Nortel has a periodic, risk-based, integrated environment, health and safety audit program.
 
    Nortel’s environmental program focuses its activities on design for the environment, supply chain and packaging reduction issues. Nortel works with its suppliers and other external groups to encourage the sharing of non-proprietary information on environmental research.
 
    Nortel is exposed to liabilities and compliance costs arising from its past and current generation, management and disposal of hazardous substances and wastes. As of September 30, 2004, the accruals on the consolidated balance sheet for environmental matters were $31. Based on information available as of September 30, 2004, management believes that the existing accruals are sufficient to satisfy probable and reasonably estimable environmental liabilities related to known environmental matters. Any additional liability that may result from these matters, and any additional liabilities that may result in connection with other locations currently under investigation, are not expected to have a material adverse effect on the business, results of operations, financial condition and liquidity of Nortel.

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    Nortel has remedial activities under way at 12 sites which are either currently or previously owned or occupied facilities. An estimate of Nortel’s anticipated remediation costs associated with all such sites, to the extent probable and reasonably estimable, is included in the environmental accruals referred to above in an approximate amount of $31.
 
    Nortel is also listed as a potentially responsible party (“PRP”) under the U.S. Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) at six Superfund sites in the U.S. An estimate of Nortel’s share of the anticipated remediation costs associated with such Superfund sites is expected to be de minimis and is included in the environmental accruals of $31 referred to above.
 
    Liability under CERCLA may be imposed on a joint and several basis, without regard to the extent of Nortel’s involvement. In addition, the accuracy of Nortel’s estimate of environmental liability is affected by several uncertainties such as additional requirements which may be identified in connection with remedial activities, the complexity and evolution of environmental laws and regulations, and the identification of presently unknown remediation requirements. Consequently, Nortel’s liability could be greater than its current estimate.
 
20.   Subsequent events
 
    Nortel Audit Committee Independent Review; restatements; related matters
 
    As previously announced by Nortel in October 2003, in late October 2003 the Nortel Audit Committee initiated the Independent Review of the facts and circumstances leading to the First Restatement and engaged WCPHD to advise it in connection with the Independent Review.
 
    On March 10, 2004, Nortel announced that as a result of the work done to date in connection with the Independent Review, it was re-examining the establishment, timing of, support for and release to income of certain accruals and provisions in prior periods. Further, it was likely that Nortel would need to revise its previously announced unaudited results for the year ended December 31, 2003, and the results reported in certain of its quarterly reports for 2003, and to restate its previously filed financial results for one or more earlier periods. Nortel announced on March 15, 2004 that the filing of the 2003 Annual Reports would be delayed beyond March 30, 2004.
 
    On April 5, 2004, Nortel announced that the SEC had issued a formal order of investigation in connection with Nortel’s previous restatement of its financial results for certain periods, as announced in October 2003, and Nortel’s announcements in March 2004 regarding the likely need to revise certain previously announced results and restate previously filed financial results for one or more earlier periods. The matter had been the subject of an informal SEC inquiry. On April 13, 2004, Nortel announced that it had received a letter from the staff of the Ontario Securities Commission (“OSC”) advising that there is an OSC Enforcement Staff investigation into the same matters that are the subject of the SEC investigation.
 
    On April 28, 2004, Nortel announced that the Independent Review was extended to include the second half of 2003 and it was determined that the previously announced unaudited results for the year ended December 31, 2003 needed to be revised and that the financial results reported in each of Nortel’s quarterly periods of 2003 and for earlier periods including 2002 and 2001 needed to be restated. Nortel also announced that it and NNL were not expected to timely file their first quarter 2004 financial statements and, in accordance with Canadian securities regulations, their 2003 Canadian GAAP audited financial statements and Annual Information Form.
 
    In April 2004, Nortel terminated for cause its former president and chief executive officer, former chief financial officer and former controller and, in August 2004, seven additional senior finance employees with significant responsibilities for Nortel’s financial reporting as a whole or for their respective business units and geographic regions in August 2004.
 
    On May 14, 2004, Nortel announced that it had received a Federal Grand Jury Subpoena for the production of certain documents, including financial statements and corporate, personnel and accounting records, prepared during the period from January 1, 2000 to the date of the subpoena. The materials sought are pertinent to an ongoing criminal investigation being conducted by the U.S. Attorney’s Office for the Northern District of Texas, Dallas Division.
 
    On May 17, 2004, Nortel announced that the OSC had issued a temporary order that prohibits all trading by directors, officers and certain current and former employees in the securities of Nortel and NNL, which temporary order was replaced with a final order issued on May 31, 2004. The final order remains in effect until two full business days following the receipt by the OSC of all filings required to be made by Nortel and NNL pursuant to Ontario securities laws.

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    On June 29, 2004, Nortel announced that it did not expect to timely file financial statements for the second quarter of 2004 and related periodic reports in accordance with U.S. and Canadian securities laws.
 
    On August 16, 2004, Nortel received a letter from the Integrated Market Enforcement Team of the Royal Canadian Mounted Police (“RCMP”) advising Nortel that the RCMP would be commencing a criminal investigation into Nortel’s financial accounting situation.
 
    On August 19, 2004, Nortel announced a new streamlined organizational structure, effective October 1, 2004, that involved, among other things, combining the businesses of Nortel’s four segments into two business organizations: (i) Carrier Networks and Global Operations, and (ii) Enterprise Networks. Further, a focused workforce reduction of approximately 3,250 employees was announced. In addition, the Audit Committee anticipated that there would be work done, in addition to that portion of the inquiry which affected Nortel’s and NNL’s ability to finalize their 2003 audited financial statements, in connection with its Independent Review, on remedial measures, internal controls and improvements to processes.
 
    On October 27, 2004, Nortel announced that Nortel and NNL did not expect to file their third quarter 2004 financial statements, and the related periodic reports, by the required deadlines in November 2004 in compliance with certain U.S. and Canadian securities regulations.
 
    Nortel has terminated for cause 10 individuals, including its former president and chief executive officer, its former chief financial officer and its former controller. Nortel has demanded repayment by the individuals terminated for cause of payments made under Nortel bonus plans in respect of 2003. Nortel has commenced litigation against its former president and chief executive officer, former chief financial officer and former controller seeking the return of payments made to such individuals under Nortel’s bonus plans in respect of 2003.
 
    Subsequent to the March 10, 2004 announcement, numerous class action complaints, including ERISA class action complaints, have been filed against Nortel in the U.S. and Canada. In addition, a derivative action complaint has been filed against Nortel. Nortel is subject to significant pending civil litigation which, if decided against Nortel, could result in substantial damages or other penalties which, in turn, could have a material adverse effect on the business, results of operations, financial condition and liquidity of Nortel (see note 19).
 
    In January 2005, the Audit Committee reported the findings of the Independent Review, together with its recommendations for governing principles for remedial measures that were developed for the Audit Committee by WCPHD. Each of Nortel’s and NNL’s Boards of Directors has adopted those recommendations in their entirety and directed management to develop a detailed plan and timetable for their implementation, and will monitor their implementation.
 
    Also in January 2005, the Nortel Audit Committee determined to review the facts and circumstances leading to the restatement of certain revenues for specific transactions identified in the Second Restatement. This review will have a particular emphasis on the underlying conduct that led to the initial recognition of these revenues. The Audit Committee will develop any appropriate additional remedial measures, and has engaged WCPHD to advise it in connection with such review.
 
    EDC Support Facility
 
    On October 29, 2004, NNL obtained a new waiver from EDC (the “October Waiver”) which replaced the September Waiver on substantially the same terms as the September Waiver except that the October Waiver remained in effect until the earliest of certain events or November 19, 2004.
 
    A further waiver was obtained from EDC effective November 19, 2004 (the “November Waiver”) related to the delay in filing the Reports and the Related Breaches, which waiver was to remain in effect until the earliest of certain events or December 10, 2004.
 
    On December 10, 2004, NNL obtained a new waiver from EDC (the “December Waiver”) which replaced the November Waiver on substantially the same terms as the November Waiver except that: (i) the December Waiver included an amendment to the EDC Support Facility to extend the termination date of the EDC Support Facility to December 31, 2006 from December 31, 2005; and (ii) the December Waiver remained in effect until the earliest of certain events or January 15, 2005.

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    On January 14, 2005, NNL obtained a new waiver from EDC (the “January Waiver”) which replaced the December Waiver on substantially the same terms as the December Waiver except that the January Waiver remained in effect until the earliest of certain events or February 15, 2005. As previously announced, Nortel and NNL have filed their respective 2003 Annual Reports, First Quarter Reports and Second Quarter Reports.
 
    On February 15, 2005, NNL obtained a new waiver from EDC (the “February Waiver”) which replaced the January Waiver on substantially the same terms as the December Waiver except that the February Waiver remained in effect until the earliest of certain events or March 15, 2005.
 
    On March 15, 2005, NNL obtained a new waiver from EDC (the “March Waiver”) which replaced the February Waiver on substantially the same terms as the February Waiver except that the March Waiver remains in effect until the earliest of certain events including the date on which Nortel and NNL have filed the Third Quarter Reports and the 2004 Annual Reports or April 30, 2005.
 
    If Nortel and NNL do not file the 2004 Annual Reports by April 30, 2005, EDC will have the right on such date (absent a further waiver in relation to the delayed filings and the Related Breaches) to: (i) terminate the EDC Support Facility; (ii) exercise certain rights against collateral; or (iii) require NNL to cash collateralize all existing support.
 
    In addition, the Related Breaches will continue beyond the filing of the 2004 Annual Reports. Accordingly, EDC will have the right beginning on the earlier of the date the 2004 Annual Reports are filed with the SEC, or April 30, 2005 (absent a further waiver of the Related Breaches) to terminate or suspend the EDC Support Facility and exercise certain other rights against collateral notwithstanding the filing of the 2004 Annual Reports. While NNL is seeking a permanent waiver from EDC in connection with the Related Breaches, there can be no assurance that NNL will receive any waiver or as to the terms of any such waiver. The $300 revolving small bond sub-facility will not become committed support until the 2004 Annual Reports have been filed with the SEC, the trustees under Nortel’s and NNL’s public trust indentures and EDC and NNL obtains a permanent waiver of the Related Breaches.
 
    Debt securities
 
    As a result of the delays in filing the Reports and the 2004 Annual Reports, Nortel and NNL were not in compliance with their obligations to deliver their Reports and do not expect to be in compliance with their obligations to deliver the 2004 Annual Reports to the trustees under Nortel and NNL’s public debt indentures. As of February 28, 2005, approximately $1,800 of notes of NNL (or its subsidiaries) and $1,800 of convertible debt securities of Nortel were outstanding.
 
    These delays have not resulted in an automatic event of default and acceleration of the outstanding long-term debt and such default and acceleration cannot occur unless notice of such non-compliance from holders of 25% of the outstanding principal amount of any relevant debt securities is provided to Nortel or NNL, as applicable, and Nortel or NNL, as applicable, fail to file and deliver the relevant report within 90 days after such notice is provided, all in accordance with the terms of the indentures. While such notice could have been given at any time after March 30, 2004, neither Nortel nor NNL has received a notice to the date of this report.
 
    Although Nortel and NNL have filed the 2003 Annual Reports and the Quarterly Reports, as a result of the delay in filing the 2004 Annual Reports, Nortel and NNL will continue not to be in compliance with their obligations under Nortel’s and NNL’s public debt indentures as described above. If notice were given, Nortel believes that it is probable that it and NNL would file and deliver the 2004 Annual Reports within 90 days of receipt of such a notice. In the unlikely event that acceleration of Nortel and NNL’s debt securities were to occur, Nortel may be unable to meet its payment obligations.
 
    Stock exchanges
 
    As a result of the delay in filing the 2004 Annual Reports, Nortel is in breach of the continued listing requirements of the New York Stock Exchange (“NYSE”) and the Toronto Stock Exchange (“TSX”). To date, neither the NYSE nor the TSX has commenced any suspension or delisting procedures in respect of Nortel Networks Corporation common shares or other of Nortel’s or NNL’s listed securities. The commencement of any suspension or delisting procedures by either exchange remains, at all times, at the discretion of such exchange.

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    Evolution of Nortel’s supply chain strategy
 
    On June 29, 2004, Nortel announced an agreement with Flextronics International Ltd. (“Flextronics”), regarding the divestiture of substantially all of Nortel’s remaining manufacturing operations, including product integration, testing and repair operations carried out in Nortel’s Systems Houses in Calgary and Montreal, Canada and Campinas, Brazil, as well as certain activities related to these locations, including the management of the supply chain, related suppliers, and third-party logistics. In Europe, Flextronics has made an offer to purchase similar operations at Nortel’s Monkstown, Northern Ireland and Chateaudun, France Systems Houses, subject to the completion of the required information and consultation process.
 
    Under the terms of the agreement and offer, Flextronics will also acquire Nortel’s global repair services, as well as certain design assets in Ottawa and Monkstown related to hardware and embedded software design, and related product verification for certain established optical products.
 
    Nortel and Flextronics have entered into a four year supply agreement for manufacturing services (whereby Flextronics will manage approximately $2,500 of Nortel’s annual cost of sales) and a three year supply agreement for design services. The portion of the transaction related to the optical design activities in Ottawa and Monkstown was completed on November 1, 2004. On February 8, 2005, Nortel announced the completion of the portion of the transaction related to the manufacturing activities in Montreal. Nortel previously reported that the portion of the transaction related to the manufacturing activities in Calgary is expected to close in the second quarter of 2005 and that the balance of the transaction is expected to close on separate dates occurring during the first half of 2005. Nortel and Flextronics are currently discussing the timing of the remaining transactions in order to optimize the business transition between the companies. These transactions are subject to customary conditions and regulatory approvals.
 
    The successful completion of the agreement and offer with Flextronics will result in the transfer of approximately 2,500 employees from Nortel to Flextronics. Nortel expects to receive cash proceeds ranging from approximately $675 to $725, which will be allocated to each separate closing and, with respect to each closing, will be paid on an installment basis up to nine months thereafter. Such payments will be subject to a number of adjustments, including potential post-closing date asset valuations and potential post-closing indemnity payments. Flextronics also has the ability in certain cases to exercise rights to sell back to Nortel certain inventory and equipment after the expiration of a specified period (of up to fifteen months) following each respective closing date. Nortel does not expect such rights to be exercised with respect to any material amount of inventory and/or equipment. The cash proceeds estimate is comprised of approximately $475 to $525 for inventory and equipment and $200 for intangible assets. The cash proceeds would be partially offset by related estimated transaction costs (including transition, potential severance, and information technology implementation and real estate costs) of approximately $200.
 
    As a result of the proposed sale of the Northern Ireland Systems House to Flextronics, Nortel has determined that it is probable that certain grants received from government agencies related to employment achievement targets will have to be repaid. The total grants received which could be subject to repayment is approximately $35 of which Nortel expects to have to make repayments of $11.
 
    Other
 
    On October 26, 2004, Nortel entered into an agreement with Foundry Networks, Inc. (“Foundry”) to settle outstanding patent infringement claims and counterclaims by the parties. As part of the settlement, Nortel granted Foundry a four year license under certain patents, and Foundry paid $35 to Nortel. Nortel recorded a gain of approximately $8 in the fourth quarter of 2004 in other income (expense) — net related to a past infringement, the remaining gain of $27 represents prepaid future royalties to be recognized ratably over four years.
 
    On December 15 and 16, 2004, Nortel sold certain notes receivable and convertible notes receivable that had been received as a result of the restructuring of a customer financing arrangement for cash proceeds of $116. The net carrying amount of the notes receivable and convertible notes receivable was $61.
 
    On December 23, 2004, a customer financing arrangement was restructured. The notes receivable that were restructured had a net carrying amount as of December 31, 2003 of $13, net of provisions for doubtful accounts of $147 ($55 of the provision is included in discontinued operations). The restructured notes were valued at $96 and a gain of $51 ($23 of the gain is included in discontinued operations) has been recorded in the fourth quarter of 2004. On January 25, 2005, Nortel sold this receivable for cash proceeds of $110.
 
    On January 20, 2005, Nortel signed a Joint Venture Framework Agreement with China Putian Corporation to establish a joint venture for R&D, manufacture and sale of third generation (3G) mobile telecommunications equipment and

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    products to customers in China. Nortel expects to have a definitive joint venture agreement by June 30, 2005. Nortel anticipates that it will own 49% of the joint venture and China Putian will own 51%.
 
    On January 23, 2005, Nortel signed a Memorandum of Understanding with LG Electronics to establish a joint venture for providing high quality, leading edge telecommunications equipment and networking solutions to Korea and other markets globally. The proposed joint venture is subject to execution of a definitive agreement. Nortel expects to complete this transaction in the second quarter of 2005. In the proposed joint venture, Nortel anticipates that it will have 50% plus one share.
 
21.   Reconciliation from U.S. GAAP to Canadian GAAP
 
    New Canadian securities regulations allow issuers that are required to file reports with the SEC, upon meeting certain conditions, to satisfy their Canadian continuous disclosure obligations by using financial statements prepared in accordance with U.S. GAAP. Accordingly, for fiscal 2004 and 2005, Nortel will include in the notes to its consolidated financial statements a reconciliation highlighting the material differences between its financial statements prepared in accordance with U.S. GAAP as compared to financial statements prepared in accordance with accounting principles generally accepted in Canada (“Canadian GAAP”). Subsequent to 2005, no further interim reconciliation will be required under current Canadian securities regulations. Prior to 2004, Nortel prepared interim financial statements (with accompanying notes) and Management’s Discussion and Analysis — Canadian Supplement in accordance with Canadian GAAP, all of which were presented as a separate report and filed with the relevant Canadian securities regulators in compliance with its Canadian continuous disclosure obligations.
 
    The consolidated financial statements of Nortel have been prepared in accordance with U.S. GAAP and the accounting rules and regulations of the SEC which differ in certain material respects from those principles and practices that Nortel would have followed had its consolidated financial statements been prepared in accordance with Canadian GAAP. The following is a reconciliation of the net earnings (loss) between U.S. GAAP and Canadian GAAP for the three and nine months ended September 30, 2004 and 2003:
                                 
 
    Three months ended September 30,
    Nine months ended September 30,
 
    2004     2003     2004     2003  

 
 
          As restated *           As restated *
 
                               
Net earnings (loss)
                               
U. S. GAAP
  $ (259 )   $ 131     $ (184 )   $ (94 )
Deferred stock option compensation (a)
          1             16  
Derivative accounting (b)
          (8 )     22       (14 )
Financial instruments (c)
    (17 )     (16 )     (49 )     (47 )
Cumulative effect of accounting change — net of tax (d)
                      12  
Other
    10       3       16       (36 )

 
Canadian GAAP
  $ (266 )   $ 111     $ (195 )   $ (163 )

 
  *   See note 21(j).

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    The following details the material differences between U.S. GAAP and Canadian GAAP for balance sheet information as of September 30, 2004 and December 31, 2003:
                                                 
 
    September 30, 2004
    December 31, 2003
 
    U.S.             Canadian     U.S.             Canadian  
    GAAP     Adjustments     GAAP     GAAP     Adjustments     GAAP  

 
ASSETS
                                               
Current assets (h)
  $ 7,698     $ 7     $ 7,705     $ 8,529     $ 3     $ 8,532  
Investments (e)
    170             170       244       (105 )     139  
Plant and equipment — net
    1,591       (1 )     1,590       1,656       (5 )     1,651  
Goodwill (a)
    2,304       (909 )     1,395       2,305       (910 )     1,395  
Intangible assets — net (i)
    79       (41 )     38       86       (41 )     45  
Deferred income taxes — net (i)
    3,610       (198 )     3,412       3,397       (197 )     3,200  
Other assets (b) (i)
    337       (25 )     312       374       25       399  

 
Total assets
  $ 15,789     $ (1,167 )   $ 14,622     $ 16,591     $ (1,230 )   $ 15,361  

 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                                               
Current liabilities (g) (h)
  $ 4,462     $ 6     $ 4,468     $ 5,002     $ 5     $ 5,007  
Long-term debt (b) (c)
    3,862       (309 )     3,553       3,891       (382 )     3,509  
Deferred income taxes — net (i)
    170       8       178       191       13       204  
Other liabilities (b) (i)
    2,938       (1,225 )     1,713       2,945       (1,154 )     1,791  

 
Total liabilities
    11,432       (1,520 )     9,912       12,029       (1,518 )     10,511  

 
Minority interests in subsidiary companies
    619             619       617             617  
Total shareholders’ equity (c) (e) (g) (i)
    3,738       353       4,091       3,945       288       4,233  

 
Total liabilities and shareholders’ equity
  $ 15,789     $ (1,167 )   $ 14,622     $ 16,591     $ (1,230 )   $ 15,361  

 

    The significant differences between U.S. GAAP and Canadian GAAP that impact the consolidated financial statements of Nortel include the following:

  (a)   Business combinations
 
      All of Nortel’s business combinations have been accounted for using the purchase method. Until June 30, 2001, under Canadian GAAP, when common share consideration was involved, the purchase price of Nortel acquisitions was determined based on the average trading price per Nortel Networks Corporation common share for a reasonable period before and after the date the transaction was closed. Under U.S. GAAP, when common share consideration was involved, the purchase price of the acquisitions was determined based on the average price per Nortel Networks Corporation common share for a reasonable period before and after the date the acquisition was announced or the date on which the exchange ratio became fixed. After June 30, 2001, treatment under Canadian GAAP was the same as under U.S. GAAP for measurement of share consideration. As a result of the difference between Canadian GAAP and U.S. GAAP until June 30, 2001, the value of purchase price consideration assigned to acquisitions may have varied significantly depending on the length of time between the announcement date and the closing date of the transaction and the volatility of Nortel Networks Corporation common share price within that time frame.
 
      Stock options assumed on acquisitions were recorded at fair value for acquisitions on or after July 1, 2000 under U.S. GAAP, and for acquisitions on or after July 1, 2001 under Canadian GAAP. Beginning with acquisitions completed subsequent to July 1, 2000, U.S. GAAP requires an allocation of a portion of the purchase price to deferred compensation related to the intrinsic value of unvested options held by employees of the companies acquired. The deferred compensation is amortized to net earnings (loss) based on the remaining vesting period of the option awards. With the adoption of the Canadian Institute of Chartered Accountants (“CICA”) Handbook Section 3870, “Stock-based Compensation and Other Stock-based Payments”, on January 1, 2002, unearned compensation is recorded on unvested options held by employees of acquired companies. Previously, there was no requirement to record deferred compensation in respect of such unvested options under Canadian GAAP. Nortel has not completed any acquisitions subsequent to January 1, 2002. The difference in accounting for options assumed or issued to the value ascribed under U.S. GAAP as part of acquisitions discussed above can result in a different balance being ascribed to goodwill under U.S. GAAP.
 
      The potential differences in the initial measurement of goodwill in business combinations under Canadian GAAP and U.S. GAAP may result in a difference in the amount of any subsequent goodwill impairment charge. Effective January 1, 2002, under both U.S. GAAP and Canadian GAAP, the method used in accounting for goodwill changed

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      from an amortization method to an impairment only method, thereby eliminating any impact on net earnings (loss) due to the amortization of different amounts of goodwill during these periods.
 
  (b)   Derivative accounting
 
      Under U.S. GAAP, effective January 1, 2001, Nortel adopted SFAS 133, which was subsequently amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities — an Amendment of SFAS No. 133”, and SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. Under Canadian GAAP, gains and losses on derivatives that are designated as hedges and that manage the underlying risks of anticipated transactions are not recorded until the underlying hedged item is recorded in net earnings (loss) and hedge ineffectiveness is not recorded until settlement. Under U.S. GAAP, the accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For fair value hedges, changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are reported in net earnings (loss) from continuing operations immediately. For cash flow hedges, the effective portion of the gains or losses is reported as a component of other comprehensive income (loss) and the ineffective portion is reported in net earnings (loss) from continuing operations immediately. Foreign currency hedges can fall into either fair value hedges or cash flow hedges and are accounted for accordingly.
 
      Under U.S. GAAP, an embedded derivative is accounted for at fair value separate from the host contract when certain specified conditions are met. Under Canadian GAAP, embedded derivatives are not accounted for separately from the host contract.
 
      Effective January 1, 2004, Nortel adopted Accounting Guideline 13, “Hedging Relationships” (“AcG-13”), which establishes specific criteria for derivatives to qualify for hedge accounting. Nortel had been previously applying these criteria under U.S. GAAP, therefore, there was no impact on adoption of AcG-13.
 
      Concurrent with the adoption of AcG-13, Nortel also adopted the CICA’s Emerging Issues Committee (“EIC”) 128, “Accounting for Trading, Speculative or Non-Hedging Derivative Financial Instruments” (“EIC 128”), which requires that certain freestanding derivative instruments that give rise to a financial asset or liability, and do not qualify for hedge accounting under AcG-13, be recognized on the balance sheet and measured at fair value, with changes in fair value recognized in earnings (loss) in each period. As a result of the adoption of EIC 128, certain warrants, which had been previously recorded at cost under Canadian GAAP, are required to be recorded at fair value consistent with U.S. GAAP. The impact of this accounting change, which has been recorded prospectively as at January 1, 2004, was an increase to investments and other income of $23 during the nine months ended September 30, 2004. Also as a result of this change, beginning in the second quarter of 2004, Nortel has no significant differences between U.S. and Canadian GAAP for its derivative accounting.
 
  (c)   Financial instruments
 
      Under Canadian GAAP, a financial instrument that contains both a liability and equity component must be allocated to those components based on fair value. As a result, the $1,800 proceeds on the 4.25% Convertible Senior Notes issued on August 15, 2001, convertible at the holders’ option into Nortel Networks Corporation common shares, were allocated based on the fair value of the debt component calculated at $1,325, with the residual of $475 being assigned to the equity component. Under Canadian GAAP, the debt component is accreted to the face value of the 4.25% Convertible Senior Notes over their seven year term, with the resulting charge recorded in interest expense. Under U.S. GAAP, such instruments are not broken out into their component parts but rather are reported as the type of instrument of which they are principally comprised. Therefore the 4.25% Convertible Senior Notes are reported as debt under U.S. GAAP.
 
  (d)   Asset retirement obligations
 
      Under U.S. GAAP, Nortel adopted SFAS 143 effective January 1, 2003, and recorded a cumulative effect of accounting change, net of tax within net earnings (loss) on the date of adoption. Nortel adopted similar Canadian guidance, CICA Handbook Section 3110, “Asset Retirement Obligations”, effective January 1, 2004, with retroactive restatement of prior periods. Under Canadian GAAP, the cumulative effect of adoption as of January 1, 2003 was recorded as an adjustment to opening accumulated deficit, as opposed to an adjustment within net earnings (loss) under U.S. GAAP, resulting in a difference of $12.

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  (e)   Investments
 
      Under U.S. GAAP, certain investment securities deemed available-for-sale by Nortel are remeasured to fair value each period, with unrealized holding gains (losses) included in other comprehensive income (loss) until realized. Under Canadian GAAP, these investments are recorded at historical cost unless a loss, that is considered other than temporary, occurs.
 
  (f)   Other financial statement presentation differences
 
      Under Canadian GAAP, global investment tax credits are required to be deducted from R&D expense while under U.S. GAAP, these amounts are required to be deducted from the income tax benefit (expense). The impact of this difference in the three and nine months ended September 30, 2004 of $10 and $35, respectively, and in the three and nine months ended September 30, 2003 of $9 and $28, respectively, was to increase or decrease net earnings (loss) from continuing operations before income taxes, non-controlling interests and equity in net loss of associated companies under Canadian GAAP, with a corresponding increase or decrease in income tax benefit (expense).
 
      Under Canadian GAAP, Nortel is required to present a consolidated statement of cash flows for the three and nine months ended September 30, 2004 and 2003, whereas under U.S. GAAP, a consolidated statement of cash flows is only required for the nine months ended September 30, 2004 and 2003. The following table presents consolidated statement of cash flows data for the three and nine months ended September 30, 2004 and 2003 prepared in accordance with Canadian GAAP. There are no significant differences between U.S. and Canadian GAAP that impact the consolidated statement of cash flows.
                                 
 
    Three months ended September 30,
    Nine months ended September 30,
 
    2004     2003     2004     2003  

 
Net cash from (used in) operating activities of continuing operations
  $ (232 )   $ (448 )   $ (465 )   $ (238 )
Net cash from (used in) investing activities of continuing operations
    (82 )     (48 )     (48 )     (85 )
Net cash from (used in) financing activities of continuing operations
    (31 )     (208 )     (108 )     (339 )
Effect of foreign exchange rate changes on cash and cash equivalents
    3       19       (6 )     97  

 
Net cash from (used in) continuing operations
    (342 )     (685 )     (627 )     (565 )
Net cash from (used in) discontinued operations
    24       50       21       343  

 
Net increase (decrease) in cash and cash equivalents
    (318 )     (635 )     (606 )     (222 )
Cash and cash equivalents at beginning of period
    3,713       4,206       4,001       3,793  

 
Cash and cash equivalents at end of period
  $ 3,395     $ 3,571     $ 3,395     $ 3,571  

 

  (g)   Other
 
      Under U.S. GAAP, effective December 31, 2002, Nortel adopted the disclosure requirements of FIN 45. In addition, effective January 1, 2003, Nortel adopted the initial recognition and measurement provisions of FIN 45 that require a guarantor to recognize, at the inception of certain types of guarantees, a liability for the estimated fair value of the obligation undertaken in issuing the guarantee. The recognition requirements of FIN 45 are applicable for certain guarantees issued or modified after December 31, 2002. Under Canadian GAAP, there is no requirement to recognize a liability for the estimated fair value of the obligation undertaken in issuing the guarantee. However, a contingent loss that is likely to be incurred is recognized if it can be reasonably estimated.
 
      Under U.S. GAAP, effective January 1, 2003, Nortel adopted SFAS 146. SFAS 146 requires that costs associated with an exit or disposal activity be recognized when the liability is incurred. Under Canadian GAAP, the Emerging Issues Committee (“EIC”) of the CICA issued EIC 134, “Accounting for Severance and Termination Benefits” (“EIC 134”), and EIC 135, “Accounting for Costs Associated with Exit and Disposal Activities (Including Costs Incurred in a Restructuring)” (“ EIC 135”), which harmonize the requirements with SFAS 146. Effective March 31, 2003, Nortel adopted EIC 134 and EIC 135.

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      Under U.S. GAAP, translation adjustments for self-sustaining subsidiaries are reported as a component of other comprehensive income (loss), whereas, under Canadian GAAP, these translation adjustments are classified as foreign currency translation adjustment, also a component of shareholders’ equity.
 
  (h)   Joint ventures
 
      Nortel has a number of joint ventures with other parties. Under U.S. GAAP, investments in joint ventures are accounted for under the equity method, whereas under Canadian GAAP, the proportionate consolidation method is used. The difference in accounting does not impact net earnings (loss), but does impact certain other consolidated financial statement items.
 
  (i)   Pension and other post-retirement benefits
 
      Under U.S. GAAP, a minimum additional pension liability must be recognized in the amount of the excess of the unfunded accumulated benefit obligation over the recorded pension benefit liability. An offsetting intangible pension asset is recorded equal to the unrecognized prior service costs, with any difference recorded in accumulated other comprehensive loss. No such adjustments are required under Canadian GAAP.

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  (j)   Restatement
 
      As described in note 2, Nortel has restated its consolidated financial statements for the years ended December 31, 2002 and 2001, and the quarters ended March 31, June 30, and September 30, 2003. The following table presents the impact of the Second Restatement adjustments on Nortel’s previously reported consolidated statement of operations for the three and nine months ended September 30, 2003 prepared in accordance with Canadian GAAP:

      Consolidated Statements of Operations
                                                 
 
    Three months ended September 30, 2003
    Nine months ended September 30, 2003
 
    As previously                     As previously              
    reported     Adjustments     As restated     reported     Adjustments     As restated  

 
Revenues
  $ 2,266     $ 78     $ 2,344     $ 6,981     $ (53 )   $ 6,928  
Cost of revenues
    1,072       143       1,215       3,713       308       4,021  

 
Gross profit
    1,194       (65 )     1,129       3,268       (361 )     2,907  
 
                                               
Selling, general and administrative expense
    489       33       522       1,423       44       1,467  
Research and development expense
    475       (25 )     450       1,447       (32 )     1,415  
Amortization of acquired technology and other
    32             32       98             98  
Special charges
    70       10       80       184       18       202  
(Gain) loss on sale of businesses and assets
    (20 )     3       (17 )     (28 )     19       (9 )

 
Operating earnings (loss)
    148       (86 )     62       144       (410 )     (266 )
 
                                               
Other income (expense) — net
    100       41       141       115       166       281  
Interest expense
                                               
Long-term debt
    (62 )           (62 )     (185 )     1       (184 )
Other
          (8 )     (8 )     (10 )     (12 )     (22 )

 
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net loss of associated companies
    186       (53 )     133       64       (255 )     (191 )
Income tax benefit (expense)
    (36 )     (6 )     (42 )     (33 )     (6 )     (39 )

 
 
    150       (59 )     91       31       (261 )     (230 )
Minority interests — net of tax
    (20 )     10       (10 )     (36 )     (16 )     (52 )
Equity in net loss of associated companies — net of tax
    (5 )     (8 )     (13 )     (35 )     (3 )     (38 )

 
Net earnings (loss) from continuing operations
    125       (57 )     68       (40 )     (280 )     (320 )
Net earnings (loss) from discontinued operations — net of tax
    55       (12 )     43       244       (87 )     157  

 
Net earnings (loss)
  $ 180     $ (69 )   $ 111     $ 204     $ (367 )   $ (163 )

 
 
                                               
Basic and diluted earnings (loss) per common share
                                               
— from continuing operations
  $ 0.03     $ (0.02 )   $ 0.01     $ (0.02 )   $ (0.06 )   $ (0.08 )
— from discontinued operations
    0.01       0.00       0.01       0.06       (0.02 )     0.04  

 
Basic and diluted earnings (loss) per common share
  $ 0.04     $ (0.02 )   $ 0.02     $ 0.04     $ (0.08 )   $ (0.04 )

 

      The impact of the Second Restatement adjustments for the three months ended September 30, 2003 was a decrease to net earnings prepared in accordance with Canadian GAAP and U.S. GAAP of $69 and $54, respectively and for the nine months ended September 30, 2003 was an increase to net loss prepared in accordance with Canadian GAAP and U.S. GAAP of $367 and $327, respectively. The Second Restatement adjustments primarily related to the following items, each of which reflect a number of related adjustments that have been aggregated for disclosure purposes: revenues and cost of revenues; foreign exchange; intercompany balances; special charges; other; reclassifications; and discontinued operations. See note 2 for a description of these differences. The impact of the Second Restatement adjustments was different under Canadian GAAP primarily because of adjustments to deferred stock option compensation under US GAAP. As described above (note 21(a)), there was no requirement to record deferred compensation under Canadian GAAP.

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    The following table presents the impact of the Second Restatement adjustments on Nortel’s previously reported consolidated balance sheet prepared in accordance with Canadian GAAP as of September 30, 2003:
                         
 
    As previously              
    reported     Adjustments     As restated  

 
ASSETS
                       
Current assets
                       
Cash and cash equivalents
  $ 3,570     $ 1     $ 3,571  
Restricted cash and cash equivalents
    113             113  
Accounts receivable — net
    2,065       (36 )     2,029  
Inventories — net
    928       500       1,428  
Income taxes recoverable
    63       5       68  
Future income taxes — net
    415             415  
Other current assets
    420       (15 )     405  

 
Total current assets
    7,574       455       8,029  
 
Investments
    110       41       151  
Plant and equipment — net
    1,467       196       1,663  
Goodwill
    1,323       48       1,371  
Intangible assets — net
    45             45  
Future income taxes — net
    3,079       (5 )     3,074  
Other assets
    445       (1 )     444  

 
Total assets
  $ 14,043     $ 734     $ 14,777  

 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                       
Current liabilities
                       
Notes payable
  $ 23     $     $ 23  
Trade and other accounts payable
    759       (50 )     709  
Payroll and benefit-related liabilities
    708       32       740  
Contractual liabilities
    769       (165 )     604  
Restructuring liabilities
    276       (64 )     212  
Other accrued liabilities
    2,303       411       2,714  
Long-term debt due within one year
    112       7       119  

 
Total current liabilities
    4,950       171       5,121  
 
                       
Long-term debt
    3,364       125       3,489  
Future income taxes — net
    292       (24 )     268  
Other liabilities
    1,421       368       1,789  

 
Total liabilities
    10,027       640       10,667  

 
Non-controlling interests in subsidiary companies
    613       8       621  
 
                       
SHAREHOLDERS’ EQUITY
                       
Common shares, without par value
    32,955       (349 )     32,606  
Contributed surplus
    2,453       15       2,468  
Deficit
    (32,631 )     57       (32,574 )
Foreign currency translation adjustment
    (329 )     360       31  
Equity component of convertible senior notes
    475             475  
Prepaid forward purchase contracts
    480       3       483  

 
Total shareholders’ equity
    3,403       86       3,489  

 
Total liabilities and shareholders’ equity
  $ 14,043     $ 734     $ 14,777  

 

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22.   Supplemental consolidating financial information
 
    As of September 30, 2004, and as a result of NNL’s credit ratings, various liens, pledges and guarantees were effective under security agreements entered into by NNL and various of its subsidiaries (see note 10).
 
    The security agreements were originally entered into in connection with the $1,510 December 2001 364-day credit facilities (which expired on December 13, 2002). The security became effective April 4, 2002, following Moody’s Investors Service, Inc. (“Moody’s”) downgrade of NNL’s senior long-term debt rating to below investment grade, in respect of the then existing credit facilities including the Five Year Facilities. Consequently, on April 4, 2002 and in accordance with the negative pledge covenants in the indentures for all Nortel’s outstanding public debt securities, all such public debt securities became, under the terms of the security agreements, secured equally and ratably with the obligations under NNL’s and NNI’s then existing credit facilities. NNL’s obligations under the EDC Support Facility became secured on an equal and ratable basis under the security agreements on February 14, 2003.
 
    As a result of NNL terminating the Five Year Facilities (see note 10), certain foreign security agreements entered into by NNL and various of its subsidiaries under which shares of certain subsidiaries of NNL incorporated outside of the U.S. and Canada were pledged in favor of the banks under the Five Year Facilities, EDC and the holders of Nortel and NNL’s outstanding public debt securities also terminated in accordance with their terms. In addition, guarantees by certain subsidiaries of NNL incorporated outside of the U.S. and Canada terminated in accordance with their terms. As of September 30, 2004, the security agreements pledge substantially all of the assets of NNL located in the U.S. and Canada and those of most of its U.S. and Canadian subsidiaries, including the shares of certain of NNL’s U.S. and Canadian subsidiaries, in favor of EDC and the holders of Nortel’s and NNL’s outstanding public debt securities (see note 10). In addition, certain of NNL’s wholly owned subsidiaries, including NNI, most of NNL’s Canadian subsidiaries, Nortel Networks (Asia) Limited, Nortel Networks (Ireland) Limited and Nortel Networks U.K. Limited, have guaranteed NNL’s obligations under the EDC Support Facility and Nortel’s and NNL’s outstanding public debt securities (the “Guarantor Subsidiaries”). Non-guarantor subsidiaries (the “Non-Guarantor Subsidiaries”) represented either wholly owned subsidiaries of NNL whose shares were pledged, or were the remaining subsidiaries of NNL which did not provide liens, pledges or guarantees.
 
    If NNL’s senior long-term debt rating by Moody’s returns to Baa2 (with a stable outlook) and its rating by Standard & Poor’s returns to BBB (with a stable outlook), the security and guarantees will be released in full. If the EDC Support Facility is terminated or expires, the security and guarantees will also be released in full. NNL may provide EDC with cash collateral in an amount equal to the total amount of its outstanding obligations and undrawn commitments and expenses under the EDC Support Facility (or any other alternative collateral or arrangements acceptable to EDC) in lieu of the security provided under the security agreements. Accordingly, if the EDC Support Facility is secured by cash or other alternate collateral or arrangements acceptable to EDC, the security and guarantees will also be released in full.
 
    The following supplemental consolidating financial data illustrates, in separate columns, the composition (as described below) of Nortel Networks Corporation, NNL, the Guarantor Subsidiaries, the Non-Guarantor Subsidiaries, eliminations and the consolidated total as of September 30, 2004 and December 31, 2003, and for the three and nine months ended September 30, 2004 and 2003, respectively.
 
    Investments in subsidiaries are accounted for using the equity method for purposes of the supplemental consolidating financial data. Net earnings (loss) of subsidiaries are therefore reflected in the investment account and net earnings (loss). The principal elimination entries eliminate investments in subsidiaries and intercompany balances and transactions. The financial data may not necessarily be indicative of the results of operations or financial position had the subsidiaries been operating as independent entities.

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Supplemental Consolidating Statements of Operations for the three months ended September 30, 2004:

                                                 
 
    Nortel     Nortel             Non-              
    Networks     Networks     Guarantor     Guarantor              
(millions of U.S. dollars)   Corporation     Limited     Subsidiaries     Subsidiaries     Eliminations     Total  

 
Revenues
  $     $ 779     $ 1,592     $ 709     $ (901 )   $ 2,179  
Cost of revenues
          640       1,133       521       (901 )     1,393  

 
Gross profit
          139       459       188             786  
 
                                               
Selling, general and administrative expense
          114       312       86             512  
Research and development expense
          174       258       69             501  
Amortization of acquired technology and other
                      2             2  
Deferred stock option compensation
                                   
Special charges
          4       82       7             93  
(Gain) loss on sale of businesses and assets
          (2 )     (37 )                 (39 )

 
Operating earnings (loss)
          (151 )     (156 )     24             (283 )
 
                                               
Other income (expense) — net
    (7 )     17       59       (25 )           44  
Interest expense
                                               
Long-term debt
    (21 )     (16 )           (8 )           (45 )
Other
          (2 )     (13 )     12             (3 )

 
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net loss of associated companies
    (28 )     (152 )     (110 )     3             (287 )
Income tax benefit (expense)
          2       9       19             30  

 
 
    (28 )     (150 )     (101 )     22             (257 )
Minority interests — net of tax
                      1       (8 )     (7 )
Equity in net loss of associated companies — net of tax
    (236 )     (73 )     (1 )     19       291        

 
Net earnings (loss) from continuing operations
    (264 )     (223 )     (102 )     42       283       (264 )
Net earnings (loss) from discontinued operations — net of tax
    5       5       3             (8 )     5  

 
Net earnings (loss) before cumulative effect of accounting change
    (259 )     (218 )     (99 )     42       275       (259 )
Cumulative effect of accounting change — net of tax
                                   

 
Net earnings (loss)
  $ (259 )   $ (218 )   $ (99 )   $ 42     $ 275     $ (259 )

 

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Supplemental Consolidating Statements of Operations for the three months ended September 30, 2003:

                                                 
 
    Nortel     Nortel             Non-              
    Networks     Networks     Guarantor     Guarantor              
(millions of U.S. dollars)   Corporation     Limited     Subsidiaries     Subsidiaries     Eliminations     Total  

 
Revenues
  $     $ 569     $ 1,723     $ 868     $ (816 )   $ 2,344  
Cost of revenues
          415       960       655       (816 )     1,214  

 
Gross profit
          154       763       213             1,130  
 
                                               
Selling, general and administrative expense
          78       258       191             527  
Research and development expense
          198       186       71             455  
Amortization of acquired technology and other
                      32             32  
Deferred stock option compensation
                      1             1  
Special charges
          (37 )     111       6             80  
(Gain) loss on sale of businesses and assets
                (19 )     2             (17 )

 
Operating earnings (loss)
          (85 )     227       (90 )           52  
 
                                               
Other income (expense) — net
    4       6       24       114             148  
Interest expense
                                               
Long-term debt
    (21 )     (17 )     (2 )     (5 )           (45 )
Other
                (17 )     9             (8 )

 
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net loss of associated companies
    (17 )     (96 )     232       28             147  
Income tax benefit (expense)
    (5 )           159       (190 )           (36 )

 
 
    (22 )     (96 )     391       (162 )           111  
Minority interests — net of tax
                      (1 )     (9 )     (10 )
Equity in net loss of associated companies — net of tax
    110       229       (325 )     (6 )     (21 )     (13 )

 
Net earnings (loss) from continuing operations
    88       133       66       (169 )     (30 )     88  
Net earnings (loss) from discontinued operations — net of tax
    43       32       20       11       (63 )     43  

 
Net earnings (loss) before cumulative effect of accounting change
    131       165       86       (158 )     (93 )     131  
Cumulative effect of accounting change — net of tax
                                   

 
Net earnings (loss)
  $ 131     $ 165     $ 86     $ (158 )   $ (93 )   $ 131  

 

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Supplemental Consolidating Statements of Operations for the nine months ended September 30, 2004:

                                                 
 
    Nortel     Nortel             Non-              
    Networks     Networks     Guarantor     Guarantor              
(millions of U.S. dollars)   Corporation     Limited     Subsidiaries     Subsidiaries     Eliminations     Total  

 
Revenues
  $     $ 2,443     $ 5,073     $ 2,533     $ (2,836 )   $ 7,213  
Cost of revenues
          1,648       3,488       2,019       (2,836 )     4,319  

 
Gross profit
          795       1,585       514             2,894  
 
                                               
Selling, general and administrative expense
          327       956       313             1,596  
Research and development expense
          598       649       218             1,465  
Amortization of acquired technology and other
                      7             7  
Deferred stock option compensation
                                   
Special charges
          8       78       13             99  
(Gain) loss on sale of businesses and assets
          (2 )     (38 )     (74 )           (114 )

 
Operating earnings (loss)
          (136 )     (60 )     37             (159 )
 
                                               
Other income (expense) — net
    (8 )     32       140       (52 )           112  
Interest expense
                                               
Long-term debt
    (63 )     (48 )     (1 )     (20 )           (132 )
Other
          (3 )     (50 )     35             (18 )

 
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net loss of associated companies
    (71 )     (155 )     29                   (197 )
Income tax benefit (expense)
          48       (17 )     1             32  

 
 
    (71 )     (107 )     12       1             (165 )
Minority interests — net of tax
                      (5 )     (24 )     (29 )
Equity in net loss of associated companies — net of tax
    (125 )     48       173       13       (111 )     (2 )

 
Net earnings (loss) from continuing operations
    (196 )     (59 )     185       9       (135 )     (196 )
Net earnings (loss) from discontinued operations — net of tax
    12       12       7             (19 )     12  

 
Net earnings (loss) before cumulative effect of accounting change
    (184 )     (47 )     192       9       (154 )     (184 )
Cumulative effect of accounting change — net of tax
                                   

 
Net earnings (loss)
  $ (184 )   $ (47 )   $ 192     $ 9     $ (154 )   $ (184 )

 

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Supplemental Consolidating Statements of Operations for the nine months ended September 30, 2003:

                                                 
 
    Nortel     Nortel             Non-              
    Networks     Networks     Guarantor     Guarantor              
(millions of U.S. dollars)   Corporation     Limited     Subsidiaries     Subsidiaries     Eliminations     Total  

 
Revenues
  $     $ 2,192     $ 4,986     $ 2,366     $ (2,617 )   $ 6,927  
Cost of revenues
          1,367       3,505       1,765       (2,617 )     4,020  

 
Gross profit
          825       1,481       601             2,907  
 
                                               
Selling, general and administrative expense
          307       868       283             1,458  
Research and development expense
          600       618       222             1,440  
Amortization of acquired technology and other
                      98             98  
Deferred stock option compensation
                      16             16  
Special charges
          27       171                   198  
(Gain) loss on sale of businesses and assets
          2       (6 )     (2 )           (6 )

 
Operating earnings (loss)
          (111 )     (170 )     (16 )           (297 )
 
                                               
Other income (expense) — net
    13       180       171       (62 )           302  
Interest expense
                                               
Long-term debt
    (63 )     (52 )     (2 )     (19 )           (136 )
Other
          (2 )     (47 )     27             (22 )

 
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net loss of associated companies
    (50 )     15       (48 )     (70 )           (153 )
Income tax benefit (expense)
    5       161       (139 )     (23 )           4  

 
 
    (45 )     176       (187 )     (93 )           (149 )
Minority interests — net of tax
                      (26 )     (26 )     (52 )
Equity in net loss of associated companies — net of tax
    (206 )     (256 )     (654 )     (60 )     1,138       (38 )

 
Net earnings (loss) from continuing operations
    (251 )     (80 )     (841 )     (179 )     1,112       (239 )
Net earnings (loss) from discontinued operations — net of tax
    157       157       101       22       (280 )     157  

 
Net earnings (loss) before cumulative effect of accounting change
    (94 )     77       (740 )     (157 )     832       (82 )
Cumulative effect of accounting change — net of tax
          (4 )     (8 )                 (12 )

 
Net earnings (loss)
  $ (94 )   $ 73     $ (748 )   $ (157 )   $ 832     $ (94 )

 

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Supplemental Consolidating Balance Sheets as of September 30, 2004:

                                                 
 
    Nortel     Nortel             Non-              
    Networks     Networks     Guarantor     Guarantor              
(millions of U.S. dollars)   Corporation     Limited     Subsidiaries     Subsidiaries     Eliminations     Total  

 
ASSETS
                                               
Current assets
                                               
Cash and cash equivalents
  $ 76     $ 2     $ 2,287     $ 1,025     $     $ 3,390  
Restricted cash and cash equivalents
          49       19       9             77  
Accounts receivable — net
          402       1,121       611             2,134  
Intercompany/related party accounts receivable
    49       412       1,092       955       (2,508 )      
Inventories — net
          329       709       465             1,503  
Income taxes recoverable
          14       10       29             53  
Deferred income taxes — net
          53       176                   229  
Other current assets
          13       161       138             312  

 
Total current assets
    125       1,274       5,575       3,232       (2,508 )     7,698  
 
                                               
Investments
    5,563       2,068       (6,897 )     600       (1,164 )     170  
Intercompany advances
          338       1,092       1,650       (3,080 )      
Plant and equipment — net
          450       758       383             1,591  
Goodwill
                1,958       346             2,304  
Intangible assets — net
          40       1       38             79  
Deferred income taxes — net
          1,747       1,793       70             3,610  
Other assets
    31       68       66       172             337  

 
Total assets
  $ 5,719     $ 5,985     $ 4,346     $ 6,491     $ (6,752 )   $ 15,789  

 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                                               
Current liabilities
                                               
Notes payable
  $     $ 2     $ 3     $ 8     $     $ 13  
Trade and other accounts payable
    1       325       416       (39 )           703  
Intercompany/related party accounts payable
    173       (3,488 )     3,480       2,343       (2,508 )      
Payroll and benefit-related liabilities
    1       96       282       128             507  
Contractual liabilities
          189       233       214             636  
Restructuring liabilities
          37       133       20             190  
Other accrued liabilities
    6       312       1,446       636             2,400  
Long-term debt due within one year
          11       11       (9 )           13  

 
Total current liabilities
    181       (2,516 )     6,004       3,301       (2,508 )     4,462  
 
                                               
Long-term debt
    1,800       1,525       123       414             3,862  
Deferred income taxes — net
          5       131       34             170  
Other liabilities
          910       1,795       234       (1 )     2,938  
Intercompany advances
                297       2,783       (3,080 )      

 
Total liabilities
    1,981       (76 )     8,350       6,766       (5,589 )     11,432  

 
Minority interests in subsidiary companies
                      83       536       619  
 
                                               
SHAREHOLDERS’ EQUITY
                                               
Preferred shares
          536       237       47       (820 )      
Common shares
    33,840       1,211       5,417       2,394       (9,022 )     33,840  
Additional paid-in capital
    3,261       22,086       761       19,693       (42,540 )     3,261  
Deferred stock option compensation
                      (9 )     9        
Accumulated deficit
    (32,716 )     (17,137 )     (11,092 )     (22,684 )     50,913       (32,716 )
Accumulated other comprehensive income (loss)
    (647 )     (635 )     673       201       (239 )     (647 )

 
Total shareholders’ equity
    3,738       6,061       (4,004 )     (358 )     (1,699 )     3,738  

 
Total liabilities and shareholders’ equity
  $ 5,719     $ 5,985     $ 4,346     $ 6,491     $ (6,752 )   $ 15,789  

 

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Supplemental Consolidating Balance Sheets as of December 31, 2003:

                                                 
 
    Nortel     Nortel             Non-              
    Networks     Networks     Guarantor     Guarantor              
(millions of U.S. dollars)   Corporation     Limited     Subsidiaries     Subsidiaries     Eliminations     Total  

 
ASSETS
                                               
Current assets
                                               
Cash and cash equivalents
  $ 68     $ (8 )   $ 2,963     $ 974     $     $ 3,997  
Restricted cash and cash equivalents
          25       19       19             63  
Accounts receivable — net
          314       1,462       729             2,505  
Intercompany/related party accounts receivable
    50       345       1,017       1,161       (2,573 )      
Inventories — net
          302       527       361             1,190  
Income taxes recoverable
          13       52       25             90  
Deferred income taxes — net
          67       302                   369  
Other current assets
          31       136       148             315  

 
Total current assets
    118       1,089       6,478       3,417       (2,573 )     8,529  
 
                                               
Investments
    5,728       1,995       (6,801 )     758       (1,436 )     244  
Intercompany advances
          166       661       1,595       (2,422 )      
Plant and equipment — net
          475       775       406             1,656  
Goodwill
                1,956       349             2,305  
Intangible assets — net
          40       1       45             86  
Deferred income taxes — net
          1,673       1,655       69             3,397  
Other assets
    37       102       39       196             374  

 
Total assets
  $ 5,883     $ 5,540     $ 4,764     $ 6,835     $ (6,431 )   $ 16,591  

 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                                               
Current liabilities
                                               
Notes payable
  $     $ 2     $ 3     $ 12     $     $ 17  
Trade and other accounts payable
    1       347       378       135             861  
Intercompany/related party accounts payable
    109       (4,071 )     3,217       3,318       (2,573 )      
Payroll and benefit-related liabilities
    2       137       449       176             764  
Contractual liabilities
          26       272       232             530  
Restructuring liabilities
          52       129       25             206  
Other accrued liabilities
    26       356       1,558       565             2,505  
Long-term debt due within one year
          11       100       8             119  

 
Total current liabilities
    138       (3,140 )     6,106       4,471       (2,573 )     5,002  
 
                                               
Long-term debt
    1,800       1,549       127       415             3,891  
Deferred income taxes — net
                143       48             191  
Other liabilities
          930       1,774       241             2,945  
Intercompany advances
          11       297       2,114       (2,422 )      

 
Total liabilities
    1,938       (650 )     8,447       7,289       (4,995 )     12,029  

 
Minority interests in subsidiary companies
                      81       536       617  
 
                                               
SHAREHOLDERS’ EQUITY
                                               
Preferred shares
          536       237       47       (820 )      
Common shares
    33,674       1,211       5,416       2,382       (9,009 )     33,674  
Additional paid-in capital
    3,341       22,031       726       19,679       (42,436 )     3,341  
Deferred stock option compensation
                      (9 )     9        
Accumulated deficit
    (32,532 )     (17,066 )     (10,838 )     (22,851 )     50,755       (32,532 )
Accumulated other comprehensive income (loss)
    (538 )     (522 )     776       217       (471 )     (538 )

 
Total shareholders’ equity
    3,945       6,190       (3,683 )     (535 )     (1,972 )     3,945  

 
Total liabilities and shareholders’ equity
  $ 5,883     $ 5,540     $ 4,764     $ 6,835     $ (6,431 )   $ 16,591  

 

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Supplemental Consolidating Statements of Cash Flows for the nine months ended September 30, 2004:

                                                 
 
    Nortel     Nortel             Non-              
    Networks     Networks     Guarantor     Guarantor              
(millions of U.S. dollars)   Corporation     Limited     Subsidiaries     Subsidiaries     Eliminations     Total  

 
Cash flows from (used in) operating activities
                                               
Net earnings (loss) from continuing operations
  $ (196 )   $ (59 )   $ 185     $ 9     $ (135 )   $ (196 )
Adjustments to reconcile net loss from continuing operations to net cash from (used in) operating operating activities, net of effects from acquisitions and divestitures of businesses:
                                               
Amortization and depreciation
          31       132       97             260  
Non-cash portion of special charges and related asset write downs
                                   
Equity in net loss of associated companies
    125       (48 )     (173 )     (13 )     111       2  
Stock option compensation
          29       15       11             55  
Deferred income taxes
      &nbs